Falls Church, VA—Yesterday a colleague noted the precipitous fall in US Treasury yields and asked me if Treasuries were the next bubble. He also asked my view of the level of consumer debt in other developed markets, the UK in particular because the economic development models are similar.

My answer to the bubble question was “yes.” Because the Fed is wading deeper into this credit mess, the outright buying of Treasuries will make them a mainstream investment vehicle.

When I recommended holding Treasuries as a hedge to our long positions in Asia in early 2006, the talk in the market was inflation. Treasury bonds were disliked while they kept dishing out solid returns.

That said, I expect that US debt will need to be repriced eventually, as investors demand higher yields. Furthermore, the US dollar/US debt relationship will also present a problem in the future, as the greenback will remain artificially strong for a lot longer because of this demand for Treasuries.

The final leg will be a gradual drop of the Treasuries and, consequently, the US dollar.

On the debt issue, the UK’s household debt-to-disposable income ratio is around 163 percent, much worse than the 129 percent in the US. It’s by no means only the US household that’s been living beyond its means; a lot of people in the Anglo-Saxon economies have done the same.

The problem is that the size of the US economy makes any mishap more important to the rest of the world. Nevertheless, the CDS spread on the 10-year UK government note has shot to the moon (as the chart below indicates), and is substantially higher than the 10-year CDS on its US Treasury counterpart.

According to the latest news, UK Prime Minister Gordon Brown is to grant homeowners in financial difficulty the right to demand a two-year “mortgage holiday” guaranteed by taxpayers. This move, if finalized, should make the situation more dire for the UK economy and should have negative long-term effects for the British pound. It seems the pound sterling may be joining the euro after all. And although this will be a very difficult move to make, serious investors shouldn’t treat it as impossible anymore.

Source: Bloomberg

Turning to Asia, last week was the first week of foreign investor net buying (USD700 million) since May. Given the negative sentiment and depressed valuations, this is a positive factor. Although a positive week doesn’t make a trend, Asia remains the best long-term bet for investors. I’ll expand on this next week as we get ready to fine tune the Portfolio for 2009.

As noted here last week, I’m thinking of adding some cyclicality to the Portfolio as our defensive positions should offer good support.

On the economic front, China’s National Development and Reform Commission (NDRC) gave more details regarding the breakdown of the USD586 billion stimulus package. As the chart below indicates, my initial thoughts were quite accurate, as the government is focusing on infrastructure investment and construction. (See also Silk, 12 November 2008, The Rise of the State.)

Source: National Development and Reform Commission

The government is also considering additional measures to stimulate consumption. Among the ideas floating: increase government subsidies to low-income workers; increase spending on social safety net programs; and continue the interest rate cutting policy.

Heavy machinery producer Lonking Holdings (Hong Kong: 3339, OTC: LONKF) has been my favorite play on China’s infrastructure efforts. The company has been facing a slowdown in sales domestically and internationally. Its main wheel loader division has been hurt the most because significant customer exposure to mining led to a 37 percent drop in units delivered in October. The company is still up 17 percent on sales this year, but it will take some time until the new stimulus plan starts having a positive effect.

That said, there’s been some skepticism regarding Lonking’s cash flows, as the company has been buying in the open market shares of a 0 percent convertible bond it had issued. The bond is due in 2012, but because of the fall in prices management felt it could retire some of the debt earlier.

I don’t see any problem with cash flow (although these things can change very fast in this environment), and I expect Chinese banks will be lending to well-positioned players in the industry. The company should be able to increase its credit lines if needed in order to get over the rough times.

Lonking is the only China-based construction machinery company that can be bought by foreign investors, as it is the only one that trades in Hong Kong. Lonking Holdings remains a buy.

Silk Mechanics and Company Update

The Fresh Money Buys list offers a guide to the countries I like now, in descending order. I favor the sectors in parentheses, and that also indicates my order of preference for companies listed in the Portfolio.

For instance, my favorite market right now is China, and my favorite company there is disposable baby diaper, sanitary napkin, and tissues manufacturer Hengan International (Hong Kong: 1044, OTC: HEGIF).

Note that the Portfolio has a clear preference for financials and telecommunications companies. The former should be the sole benefactors of falling interest rates while offering great exposure to Asia’s long-term domestic demand investment theme.

Our telecom selections offer exposure strong cash flows, sustainable dividends and growth potential. Once again, use the Fresh Money Buys list for as a guideline for fund allocation.

Frontier markets Vietnam and Cambodia are at the bottom of the list, indicating that although the long-term potential is there, their status as frontier markets means that a relatively small amount of your funds should be allocated there.

Cambodia-based Naga Corp (Hong Kong: 3918, OTC: NGCRF) merits special mention as it carries risk inherent in a truly emerging market.

It’s the only company investors can own in Cambodia, and given this country’s turbulent political past and the fact that it’s still in its early stages of economic development, you should be aware of the risks such an investment entails.

Naga remains the perfect way to get exposure to an exciting, pure emerging market opportunity in which the rewards can be substantial. See Silk, 5 March 2008, Holiday in Cambodia, for an in-depth discussion.

Naga’s advantage is that it focuses on middle-of-the-pack VIP gamblers, mainly from Malaysia, China, Singapore and Vietnam. The minimum check-in amount for these players is only USD5,000 (versus USD50,000 to USD2 million in Macau).

Because Naga has spent far less than the other casino operators in Asia in developing its property–prices are lower in Cambodia–it’s in a position to also offer more concessions to its VIP clientele. The company’s 300-room hotel also provides a steady revenue stream since its completion in September. Its services and facilities are of international standards for a very reasonable USD120 per night.

Naga has a major tax advantage, with an effective tax rate of around 3 percent (the tax is fixed at USD1.7 million, growing 12.5 percent per year), a far cry from what Macau operators are paying at 40 percent. This tax agreement is valid until 2018.

The company has no current plans for future expansion; all its facilities are completed, with extra cash being designated for dividend payments. Management has said repeatedly payout ratios will stay elevated. The dividend yield is now at 12 percent, supported by strong cash flows.

The balance sheet remains clean with no debt and USD47 million in cash. For comparison purposes, the company’s revenues for 2008 are expected to be around USD140 million while enjoying operating margins around 22 percent. Naga Corp remains a buy.

As always, I prefer the local shares–when we can get them–to the over-the-counter (OTC) listing. And because Hong Kong is easily tradable through serious brokers in the US, I strongly recommend buying the stock locally.

The Permanent Hedges

The longstanding hedging recommendations have been an integral part of my efforts to offer a more complete portfolio advice. Although Silk is an emerging market advisory and the Portfolio is always long these markets, the effort has always been to offer ways to balance the downsides.

The recommendations in the Permanent Hedges section of the Portfolio have performed respectably since recommend.

Our gold position is up 35 percent since its original recommendation in the second quarter of 2006, while our position in iShares Lehman 7-10 Year Treasury (AMEX: IEF) has returned 31 percent. The latter is, as mentioned above, a great performance, especially given the fact that at the same time period the S&P500 index is down 30 percent thus allowing the Treasuries to outperform by a stunning 61 percent.

Shorting the American consumer has also been successful; our short in Consumer Discretionary SPDR (AMEX: XLY) is up 47 percent since first recommended here at the end of 2006. It has taken sometime, but the final outcome has been as expected: a synchronized job loss and housing price decline that has led to the long awaited start of the deleveraging process for the consumer.

True, the easy money has been made here and therefore profits should be booked by long-term holders. This is a personal decision, as every reader has had a different time of entry and therefore different profits to protect.

The short will remain for now in the Permanent Hedges section of the Silk portfolio as these positions are viewed here as a counter balance to the long-only part of the Portfolio.

iShares Investment Grade Corporate Bond Fund (NYSE: LQD), which I recommended in late January, is down 9 percent. I consider this a good performance given the current market conditions and the fact that the S&P500 is down 36 percent during the same timeframe. This position makes more sense now because of the synchronized efforts to combat the credit crisis.

Finally, readers who have gains in iShares Lehman 7-10 Year Treasury or the short in Consumer Discretionary SPDR should take some money off the table and reallocate it to iShares Investment Grade Corporate Bond Fund, which offers a 5.7 percent dividend yield.

Alternative Holdings

This section of the Portfolio offers exchange traded fund recommendations for those who want to avoid buying individual stocks. Fewer stock picks are being offered here, and the ones they make it in the Alternative holding should be viewed as speculative in nature.

Alibaba.com (Hong Kong: 1688, OTC: ALBCF) and Melco PBL Entertainment (NSDQ: MPEL) are the current speculative plays. They’ve both collapsed since initially recommended, but at current levels they offer good potential upside. Neither should be part of your core holdings. I’ll keep track of them from current levels and periodically offer my outlook and advice on them.

Fresh Money Buys

The investment process is constant. If you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio tables for details.

• China (Consumer, Insurance, Banks, machinery, port, coal, e-commerce)
• Hong Kong (banking, real estate)
• Russia (energy, telecommunications)
• India (pharmaceuticals)
• Taiwan (telecommunications)
• Japan (banking)
• Philippines (telecommunications)
• Indonesia (Telecom)
• Singapore (Industrial)
• Vietnam (ETF)
• Cambodia (casino/hotels)
• Macau (casino/hotels)