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Related topics: politics, debt, bonds, portfolio, Anthony Mirhaydari

The global debt crisis, which started more than two years ago in Dubai, finally has washed ashore in the United States. Along the way, it resulted in deadly protests in Greece and threatened Europe's post-war unity. Now it will bring a new age of austerity to the U.S.

That means higher taxes, reduced spending and cuts in entitlements like Medicare.

Politicians have yet to face it, and the public hasn't accepted it. But the only alternative is a Weimar-style hyperinflation combined with a Greek-style bond market revolt. We'll do the right thing. We have no choice.

Wall Street sounded the alarm April 18 as credit analysts at Standard & Poor's doled out the first U.S. credit-outlook downgrade since the Imperial Japanese Navy bombed Pearl Harbor. Suddenly, the debt issues that cut down the spendthrifts in Athens, Lisbon and Dublin hit us at home.

So is the U.S. the new Greece? Not yet -- our credit rating hasn't been downgraded yet, for one. But there are similarities. Greece's problems stemmed from spending commitments enabled by easy credit, a growing deficit, a public liking for government services and a general dislike for taxes. That made it hard to tackle the problem until it became a crisis.

The situation here is severe. The U.S. economic recovery has been tepid, unlike the roaring recoveries in places like Germany and China. Credit Suisse notes that Gross Domestic Product (GDP) only recently reclaimed its pre-recession peak and is about 7% behind a typical recovery. And the debt load is significant: Besides Japan, there is no other rich world economy in such dire straits.

Image: Anthony Mirhaydari

Anthony Mirhaydari

Here's a look at what the S&P's warning means -- and how to get your portfolio ready for the fallout:

A shot across the bow

The S&P decision signals recognition of the government's growing debt burden and persistent deficits -- as well as the bitter political fight in Washington that threatened a government shutdown earlier this month. The cut, from "stable" to "neutral," means there is a one-third chance of a credit-rating downgrade within the next two years.

The move by S&P was inevitable as politicians play a serious game of chicken with both members of the opposite party and the bond market. The Treasury's outstanding debt nears its statutory limit sometime between the start of May and July, and the fight over raising the limit has begun.

The S&P analysts, while noting the inherent strength and flexibility of the U.S. economy, worried that no significant plan to address the debt will be put in place before the 2012 presidential elections. The real work couldn't begin before the post-election budget proposal for the fiscal year beginning Oct. 1, 2013. That's a long time from now. And waiting would push to the government's debt-to-GDP ratio to dangerous levels.

If nothing is done to curb the borrowing -- or if our credit is downgraded -- the results would be severe. Interest costs would rise. This would make the debt crisis worse by deepening the federal deficit. It would also crowd out private borrowing and increase financing costs for consumers and businesses. Banks would be forced to take losses on their reserves of U.S. Treasury bonds, prolonging the credit drought and weighing on the housing market.

We can't afford to let this happen. But do we have the stomach to take action?

The likes of Great Britain have embraced fiscal austerity despite the social pain and economic damage it causes -- indeed, U.K. GDP dropped 0.5% in the fourth quarter. Greece, Portugal, the U.K. and Spain have all pulled their deficits below the 10% level over the past year. Politicians there have made the hard choices despite electoral rejection and violent protests.

But our policymakers just can't seem to stop spending, borrowing and tax-cutting. Just four months ago, President Barack Obama and Congress teamed up to pass an $858 billion extension of the Bush-era tax cuts, along with additional payroll-tax cuts. These were added despite the fact the 2011 budget deficit is expected to hit nearly $1.7 trillion, or 11% of GDP.

According to the Organization for Economic Co-operation and Development (OECD), OECD, only the United States and Ireland maintain budget deficits of more than 10% of GDP.

We've seen a preview of things to come with the battle in Wisconsin over union rights and the recent budget fight. More acrimony lies ahead. For all the talk of cuts, a Tea Party-driven GOP won the House in 2010 in large part by saying President Obama's heath care plan would cut Medicare and hurt seniors. Obama will use the same argument against the GOP's budget plan. The 2012 election could get ugly.

The trouble with T-Bills

Still, investors are betting the outcome of this debate will be spending cuts and tax increases, if only because the alternative is worse.

You see, the global financial system is built on risk-free Treasury bonds. They are used as trade collateral. They are counted as bank reserve capital. Our creditors, including China and Saudi Arabia, hold huge amounts of them. Unlike Greece, the United States simply can't default or restructure its obligations. That's the price of our unique status as the issuer of the world's reserve currency. That status also brings benefits, including cheap financing and the ability to run persistent trade deficits.

We have to stand by our debt, no matter what.

This explains the wild volatility seen in Treasury trading on Monday after the news of the S&P downgrade watch hit the wires. First there was a plunge, which took down stocks, commodities and crude oil. But within an hour, as traders accepted that painful austerity is the end game and a U.S. debt default is out of the question, T-bonds enjoyed a massive bid and closed positive as yields fell.

The U.S. dollar also moved higher. If all this seems like twisted logic, that's because it is.

I checked in with Societe Generale economist Aneta Markowska to see what her interpretation of the market action was. She recently cut her real-time Q1 U.S. GDP estimate to just 1.25% due to weakness in retail sales, business inventories and the international trade balance. Here are her comments to me concerning the credit outlook downgrade, reprinted verbatim:

"It shouldn't impact the near-term economic outlook, unless risky assets really fall apart here. Interestingly, the bond market really took the S&P in stride, so that limits the near-term economic impact. We still look for a more respectable GDP reading in Q2 (~4%), which would be more in-line with the ISM surveys and production data.

"The potential impact of S&P's decision is medium-term. I think that the outlook change could serve as a wake-up call in Washington and increase the chances that a compromise can actually be reached this year. If so, the fiscal drag on the economy in 2012-2013 would be greater than we had assumed, and the Fed's exit could be delayed. Ironically, this means that the S&P move could actually prove supportive for the Treasury market in the medium-term."

So there you have it. A credit outlook downgrade of U.S. government debt -- on concerns we won't repay it -- in the end had a positive influence on bond prices as traders priced in the economic impact of fiscal tightening.

In simpler terms: Wall Street is betting on a new recession caused by the budget cutting and tax hikes as we deal with our debt.

Pricing in the pain

So how painful will austerity be?

Well, the cuts and tax increases currently proposed by the president and House Republicans don't come close to controlling the problem. The International Monetary Fund -- a global watchdog on fiscal matters -- has lambasted U.S. leaders for the lack of a "credible strategy" to reduce debt.

According to IMF calculations, no more than half the spending cuts and tax increases that are needed to reduce the government's debt to pre-financial crisis levels (around 60% of GDP) by 2030 have been proposed. House Budget Committee Chairman Paul Ryan, R-Wis., wants $6 trillion in cuts over 10 years; the president wants $4 trillion in savings over 12 years.

The IMF estimates that -- after accounting for age-related spending on entitlements -- the federal budget would need to be slashed by nearly $12 trillion by 2020 to reach pre-crisis levels.

Compare that number with the much-ballyhooed $38 billion "cut" from the 2011 budget agreement hammered out two weeks ago to avoid a government shutdown. This was voodoo austerity. The Congressional Budget Office estimates that actual reductions in spending amount to only $352 million, or 0.002% of GDP.

All of that heavy breathing and political posturing, and we haven't even started yet.

And one could argue that politicians are just doing what Americans want. People like the idea of a balanced budget and reduced indebtedness, but they don't like what we'd have to do to get there. In a recent USA Today/Gallup Poll, 47% of respondents said we should not make significant cuts in spending in next year's budget.

It's hard to find much support for specific actions, either. A Pew Research Center poll found that ideas including reducing funding for roads, making Medicare recipients pay more out of pocket, eliminating the home-mortgage-interest-deduction and raising the Social Security retirement age were all nonstarters. The only two ideas that attracted a majority of respondents were raising the Social Security contribution cap (a variation of tax the rich) and freezing the salaries of federal workers.

We're also facing these uncomfortable choices at a time of economic vulnerability because of increased inflationary pressure and a drop in consumer confidence.

Standard Chartered economist David Mann told clients this week that the U.S. economy "is proving to be less resilient in the face of shocks than many would have thought." And that's because consumers are still working off the excesses of the housing boom. Incomes are stagnant.

Already, Mann estimates at the GDP growth contribution from consumer spending is down to 1.3% from 2.9% in the fourth quarter. We're nearing the economy's stall speed -- and spending cuts and tax increases won't help.

Time to pull on the reins

Like the market, I think we will eventually do the right thing. But that means we're headed for another soft patch of growth as austerity bites. We had one last summer as the eurozone was forced to clamp down economically and save Greece. Now, it's America's turn.

Because of this tough patch ahead, I've recommended my newsletter clients move into conservative assets like iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and shun risky assets like commodities and economically sensitive cyclical stocks for now.

One point of concern has been the huge shift into late-stage defensive stocks like consumer staples and health care over the past two months -- ending three years of relative underperformance. Similar behavior was seen in late 2007 as the last bull market entered its final stage. Investors are hunkering down.

The trouble with diving headfirst into defensive issues, though, is that they tend to outperform early in this cycle. So be careful not to buy a price spike.

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If you are a buy-and-hold investor holding a varied portfolio, then than you should already be prepared for this movement, called sector rotation. If you like to actively manage your holdings, move away from cyclical and small-cap stocks. Hold more in cash until investors show an appetite for risk again.

And although precious metals look pricey now, I'd increase exposure to gold and silver assets -- specifically the commodity ETFs like the SPDR Gold Shares (GLD, news) and the iShares Silver Trust (SLV) -- as protection against the Federal Reserve's temptation to increase inflation as a way of easing the government's debt burden. Be sure to see my April 18 column for more on the long-term outlook for gold prices.

Disclosure: Anthony has recommended iShares iBoxx $ Investment Grade Corporate Bond to his newsletter subscribers.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.