Buy more foreign stocks

(Money Magazine) -- Even in this century's darkest days of recession and war, U.S. households kept on spending. But one of the smartest investors on the planet says the American consumer is finally out of steam.

In his new book, "When Markets Collide: Investment Strategies for the Age of Global Economic Change," Mohamed El-Erian, co-CEO of bond-investing giant Pimco, argues that this development fundamentally changes the way to invest.

Question: Economists have been predicting the demise of consumer spending for years. Why should we believe it this time?

Answer: Because there are very few shock absorbers left for U.S. consumers. They are facing a credit crunch, a sharp slow-down in the economy that has triggered higher unemployment, and price shocks in energy and in food. On top of that, they can no longer use their houses as ATMs.

Q. If we can't count on the U.S. consumer, isn't the global economy doomed?

A. In the old days, if the U.S. economy contracted, the rest of the world would do even worse. But today, if the U.S. contracts, the rest of the world might contract by only half. That's a fundamental change. The wealth of the emerging middle class in countries like Brazil, India and China is becoming a force in itself.

Q. How should investors adjust to this new world order?

A. The typical U.S. investor tends to have about 80% of equities in the U.S. The world of tomorrow suggests a much greater exposure overseas. In general, you should consider holding a third of your equities in the U.S., a third in industrial countries outside the U.S. and a third in emerging markets.

Q. Don't the emerging economies of China, India and Latin America pose a risk?

A. Absolutely. The low-cost goods exported from emerging economies helped hold down prices in the rest of the world. But as wages in those countries rise, they'll cease to be a helpful force for disinflation and start to drive inflation higher.

Q. How can investors protect themselves from that?

A. This scenario is a classic argument for holding more commodities, real estate and inflation-protected bonds. In the long run, think about keeping 20% or so of your total portfolio in these assets.

Q. Aren't they expensive now?

A. Yes, but you can invest in inflation-protected bonds issued by other countries [Editor: for example, by investing in an ETF that contains these bonds]. And there will be entry points to buy real assets at lower prices in the future. Commodity prices, for example, are volatile and likely to get more so. Arriving at that 20% should be a long-term rather than a short-term goal.