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In one sense, the downgrade simply reaffirms what everyone already knew. The US fiscal situation has deteriorated rapidly since 2008. More troubling, it also reiterates that the current structure of the large US entitlement programs and the narrow nature of the US tax base mean that after a brief respite, deficits will likely get much worse in the latter part of the decade. (I point out more about the upcoming deficit debacle in my new book “The Ten Trillion Dollar Gamble.”)

While last week’s bi-partisan deal to raise the debt ceiling alleviated the near-term pressure, the deal explicitly did not address entitlement programs and taxes, the longer-term more troubling challenges for the US fiscal situation. While it is easy to blame politicians for this short falling, as investors we should not be too surprised.

Over the past twenty-five years, big fiscal adjustments typically happen when three conditions are met: the bond market forces the issue and an election and change in government have just happened. None of these conditions are currently present in the United States , suggesting that the troubling US fiscal situation is likely to be an overhang for financial markets until 2013, at the earliest.

In the meantime, investors are caught in a market supported, at least until recently, by solid corporate fundamentals and reasonable valuations but held back by chronic sovereign debt problems in both the US and Europe .

Given these dynamics, we believe financial markets will remain volatile, particularly if the already fragile global economy continues to weaken. We believe that investors should consider remaining defensive, with allocations to equity sectors that have a lower risk profile and are less levered to the global economy.

What may be less obvious, however, is what sectors and countries fit the bill. As the developed world is the epicenter of the debt crisis, in many cases investors should look at emerging markets with strong domestic demand.

Ironically, the world’s economic ballast has shifted. Many of the markets that were viewed as dangerous even 10 years ago, now appear, particularly in comparison to much of the developed world, pictures of fiscal rectitude.

 

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.