How U.S. debt threatens the economy

Trend: The booming Asian exporting countries that buy US debt will slow their purchases, with ramifications for bonds, interest rates, and stocks.

Roger Ibbotson predicts some strength in stocks as the US struggles with high debt and increasing energy prices.

Source: MSN Money - Extra: How U.S. debt threatens the economy.

Through the ‘90s, as our trade deficit grew, our budget deficits made up only a small percentage of our GDP. We were easily able to service our debt. But war, tax cuts and Hurricane Katrina changed that. And the combination of a weighty budget deficit and a record trade deficit has made these creditor nations nervous about loading up on too much U.S. debt. It's reasonable to think that China, Japan and Southeast Asia may soon choose to diversify their investments and stop buying our debt.

If foreign countries stop buying our debt, that will cause long-term bond prices to drop, interest rates to rise and the dollar to fall. Excess demand for energy and natural resources from China and India will likely spur a rise in U.S. inflation rates. Higher interest rates and inflation coupled with a weak dollar make long-term bonds a risky investment with very little upside. Investors looking to invest new money in fixed income will be better off investing in short-term bonds.

The impact on the overall stock market is less clear -- some sectors will benefit while others will struggle. The drop in long-term bond prices may be harmful to certain types of financial firms, for example. Rising oil prices may help energy companies but hurt manufacturing, while a falling dollar may make many of our products more competitive overseas.

Overall, the market is strong and more reasonably priced today than it was a few years ago. Price-to-earnings ratios have come down from highs in the 40s in 2000 to half that today. And that ratio hasn’t come down because prices dropped, but rather because corporate earnings have increased -- a much healthier reason. Today’s lower stock valuations make the market much more attractive and should attract more money to stocks, which should drive their prices higher.