Global capital markets have tumbled again, this time in response to fiscal chaos in Greece and its implications for the wider Eurozone. In today’s integrated global economy the potential for any nation to default on its sovereign debt is disruptive. Investors, however, should not change their allocation plans in response to events external to their personal circumstances and financial objectives.
In order to qualify for membership into the Economic and Monetary Union (EMU), nations were required to meet several criteria established under the Maastricht Treaty. A member nation’s budget deficit could not exceed 3 percent of gross domestic product (GDP). In late 2009, ten years after the euro was launched, a newly elected government in Greece announced that its true ratio was closer to 13 percent. Though the Greek economy ranks only 27th in the world in GDP and accounts for only 2 percent of the Eurozone’s output, capital markets worldwide have fallen sharply as the possibility that Greece might default on its debt has grown more likely. Volatility has remained well above average despite a $146 billion aid package assembled by Eurozone nations, the International Monetary Fund (IMF) and the U.S. Federal Reserve in early May.
Behind the skepticism lies doubt that Greece will be able to impose the discipline necessary to avoid default; dramatic structural changes are required and few believe Greece has the political fortitude to implement necessary changes. But more importantly, three quarters of Greek sovereign debt is held by foreigners, and its largest creditors include French and German banks, which are still reeling from the 2008 credit market crisis.
The situation in Greece prompted bond markets to immediately focus on Spain, Italy, Ireland and Portugal which also face fiscal challenges, though far less severe. Eurozone creditors hold approximately $300 billion in Greek debt, but roughly $4 trillion in the collective sovereign debt of these nations, all of which have seen their borrowing costs increase sharply.
The bear market of 2008-2009 is fresh in the minds of most investors, and fears of a repeat performance are being fanned by the media. While rebalancing to match your target allocations may well be called for, it is never prudent to alter your target allocations amidst a climate of fear (or euphoria), and current circumstances are no exception. The temptation to flee foreign markets should be avoided.
Capital markets “price in” news as it emerges, so relative risk among nations is reflected in sovereign bond prices and yields. As events unfolded bond yields increased dramatically in the smaller nations with the weakest balance sheets, and fell among the larger Eurozone economies of Germany and France as well as in the U.K. and U.S.
The U.S. national debt has grown from roughly 60 percent of GDP to over 90 percent over the past ten years and stands roughly where it was following World War II. While this is a serious concern, comparisons with the struggling nations of Europe are overstated. The bottom fell out of the Greek bond market when it became clear that nation’s true fiscal situation had been obscured by deceptive bookkeeping. In the U.S., federal debt accounting is questionable (see AIER’s May 17, 2010 Research Reports). But these practices and the relative risks they pose have long been known and discounted by capital markets. In our estimation monetary inflating remains a far more likely outcome than default.
The world, once again, appears to regard the U.S. dollar as “The World’s Tallest Dwarf” among fiat currencies. As the crisis has grown, investors have fled to dollar denominated assets, including U.S. Treasuries, and of course, gold. Subscribers who have followed our recommendations would have held these assets in good measure, as others were racing to buy them.
What about Global Equities?
In a world of fiat currencies, all of which lose purchasing power over time, investors are best served by holding a globally diversified portfolio.
The accompanying chart and table demonstrate that since the euro was introduced in January 1999 an investor concerned with return and volatility would have been far better off holding a globally diversified equity portfolio that included both U.S. and foreign equities versus an all-U.S. equity portfolio. The data in the chart are generally consistent with the equity allocation within our recommended “moderate risk” portfolio.
Also in This Issue:
Long Term Government Bonds: The Risk/Return Paradox
From the Archives: The Great Unanswered Questions
Managers vs Markets
A Rite of Spring: The Proxy Package
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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