(Bloomberg News) Pacific Investment Management Co.'s Bill Gross said investors should favor emerging market corporate and sovereign debt as "mindless" U.S. deficit spending may result in higher inflation, a weaker dollar and the eventual loss of America's AAA credit rating.

Buying debt in emerging market countries with higher real interest rates, wider credit spreads and strong balance sheets will offer more return as well as protection from dollar depreciation as U.S policy makers run up record deficits at the expense of economic growth, Gross, the manager of the world's biggest bond fund, wrote in his monthly investment outlook.

"The problem is that politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion dollar annual deficit," Gross wrote in a note on Pimco's Web site today. "As long as the stock market pulsates upward and job growth continues, there is an abiding conviction that all is well and that 'old normal' norms have returned. Not likely. There will be pain aplenty."

The U.S. deficit was $150.4 billion in November, exceeding the median estimate of economists surveyed by Bloomberg News, compared with $120.3 billion in November 2009, according to a Treasury Department budget statement released last month.

The extension of tax cuts that President Barack Obama signed into law will expand the federal budget deficit to $1.34 trillion for fiscal 2011, Credit Suisse Group AG strategists estimated on Dec. 7. Obama announced a day earlier an agreement with congressional Republicans to extend tax cuts enacted under his predecessor, George W. Bush.

'Fear The Consequences'

Moody's Investors Service Inc. said on Dec. 13 that Obama's agreement to extend tax cuts raises the chance of a negative outlook for the U.S.'s Aaa credit rating unless offsetting measures are enacted.

"All investors should fear the consequences of mindless U.S. deficit spending." wrote Gross, a founder and co-chief investment officer at Pimco. Like a female mantis who eats the head of her mate while reproducing, policy makers are "munching on the theoretical heads of future generations, while paying no mind to the wretches that will eventually be called upon to pay the bills," he wrote.

Congress should raise the debt ceiling, or the legal limit on U.S. borrowing, before it reaches capacity in the next few months to avoid threatening the U.S. credit rating, Gross said in an interview today on CNBC. After candidates supported by anti-deficit Tea Party activists were elected on pledges to rein in spending, some lawmakers have said they would demand budget cuts in exchange for voting to raise the debt ceiling.

Yields Decline

Stimulus measures that have been designed to maintain current consumption instead of working to make America a more competitive nation in the long run will be a drag on real income growth as reflationary policies set in, Gross wrote.

In December, an 18-member debt commission convened by the Obama administration failed to produce the votes needed to approve a $3.8 trillion budget-cutting plan projected to balance the government's books by 2035.

Yields on U.S. government debt fell in 2010 as the 9.8% unemployment rate, record low inflation and Europe's sovereign-debt crisis stoked demand for safety. Bonds returned 5.9% in 2010 after losing 3.7% in 2009, according to Bank of America Merrill Lynch Indexes even as the government completed $2.2 trillion of note and bond auctions in 2010, surpassing the $2.1 trillion record set in the prior year. IntercontinentalExchange Inc.'s Dollar Index gained 1.5 percent.

'Lose Their Heads'

Bond investors will suffer once general prices start to rise, Gross wrote. He declined to be interviewed today.

"The American answer to a bulging waistline is always 'maƱana'" Gross wrote. "Eventually, as reflationary policies take hold, long-term bondholders lose their heads (and a portion of their principal as well), as yields rise to reflect higher future inflation."

Consumer prices excluding food and energy rose 0.8% in November from a year earlier after an advance of 0.6% in the prior month, the smallest gain in year-over-year data going back to 1958, the Labor Department reported Dec. 15.

Traders are adding to bets that inflation will pick up. The difference between yields on 10-year U.S. notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices over the life of the securities known as the break-even rate, has advanced to 2.38 percentage points, up from the 2010 low of 1.47 in August. The five-year average is 2.08 percentage points.

Growth Forecast

Pimco raised its forecast for U.S. growth last month with the Obama tax plan allowing policy makers to pump a "massive amount" of stimulus into the economy. The accord also calls for extending unemployment insurance for the long-term jobless and cutting the payroll tax by $120 billion for one year.

The economy is likely to grow 3% to 3.5% in the fourth quarter from the same period of 2010, Pimco Chief Executive Officer Mohamed El-Erian said Dec. 9. That compares with Newport Beach, Calif.-based Pimco's previous estimate for 2% to 2.5% growth, and the 2.2 percent gain forecast by the International Monetary Fund.

The firm has championed the idea of the new normal, in which investors will receive lower-than-historically average returns as global growth slows and the influence of the U.S. is diminished.

The $250 billion Total Return Fund managed by Gross posted an 8.74% gain in the past year, beating 75% of its peers, according to data compiled by Bloomberg. The one-month performance is a loss of 0.04 percent, beating 56% of competitors. Pimco is a unit of Munich-based insurer Allianz SE.