Seeking Stability in a Volatile World
It is difficult enough to process all of the information that we are bombarded with each day but even more so when the problems and outcomes happen at light speed. Traders with the savvy and skill to deal with volatile markets may enjoy this, but we know that there is little we can do to assuage our uneasiness. Depending upon the daily direction of the markets, our strategy is either spot on or exposed but not excessively so. It is good to remind ourselves that ours is a longer-term strategy and vision. We will probably look back on the crises of today—Greece and the Euro, the Chinese stock market, or a default in Puerto Rico—as events which created anxiety and market disruption but remained essentially contained. It goes without saying that the root cause of the world’s economic risks are tied to excessive debt. The problems associated with this debt defy acceptable solutions and will be a persistent economic drag for years
The Euro is a financial experiment on a grand scale. The idea of a common union goes back to the post World War II era. Europe sought a financial solution to the disadvantages brought about by small economies, multiple currencies, and trade barriers and in 1999 member countries gave up their currencies in exchange for the Euro. While the European Union and the creation of the Euro did provide exchange rate stability, it was flawed by the lack of political control over member budgeting and spending. With Greece among others now deeply in debt, options have been limited and the European Union has pursued a series of bailouts intended to keep the Euro alive.
While Greek debt and the potential withdrawal from the Euro can disrupt financial markets, this problem isn’t new and U.S. banks and investors have had plenty of time to insulate themselves from direct exposure. In fact, Greece’s economy is small—only .38% of the world’s GDP—and is now only two-thirds of what it was in 2008. At this moment, another last minute “deal” has been struck which may allow Greece additional time but, once again, the terms appear harsh and the reaction among Greek citizens is uncertain. The Greeks don’t want austerity policies forced upon them but can’t face the alternative either—a collapse of their financial system.
There is concern that pushing Greece out of the Euro will set a political precedent. If Greece is able to leave, others, like Spain and Portugal, might follow. DoubleLine’s Jeffrey Gundlach points out that a Greek exit and default could create a pattern that ultimately undermines faith in European Union. He believes that the Euro, without political power behind it, will not survive. Greece may be only the first of many noting that “there is never just one cockroach.” Gundlach believes that a Greek resolution will be positive for the Euro in the short run but that this strength will be temporary.
While Greece teeters, the bubble in the Chinese stock market has burst. Is this an isolated incident or something more serious? To most of us, this is a sideshow where direct exposure is extremely limited and contagion to other areas seems unlikely. Still, it is another example of financial disruption that is difficult to absorb. While China’s economy has been persistently slowing, the Shanghai index fueled by retail customers rose a spectacular 60% this year followed by a one month 30% decline. The Chinese government reaction included cutting interest rates to record lows, loaning money to brokerage firms with instructions to buy stocks, and the suspension of trading in many issues. We can’t claim a deep understanding of China’s problems (it seems no one does), but this policy is troubling and brings into question the Chinese leadership’s ability to responsibly manage their economy.
Closer to home, Puerto Rico is held in its own debt grip. Over the last 10 years, Puerto Rico’s debt has doubled to $72 billion and the Governor has recently called the debt, “not payable.” Puerto Rico has enjoyed issuing tax-free debt while suffering population declines and severe recession. How bad is it? Per Capita debt stands at $15,637 or 10 times higher than the average U.S. state. It’s complicated but Puerto Rico has limited options unless Congress provides it with the opportunity to restructure its debt—most of which is held by U.S. citizens. Puerto Rico and Greece are both examples of the end game of overwhelming debt. Taxes rise to unsustainable levels (Puerto Rico’s sales tax is now 11.5%), productive workers leave, and credit ratings and the ability to borrow are destroyed. These factors are a huge economic liability which only worsens the situation. Neither Greece nor Puerto Rico can repay their debts and keeping them on life support will not change that.
In spite of the world’s turmoil, the Fed seems bent on raising short-term interest rates this year. Chairwoman Yellen’s recent comments on the U.S. economy were upbeat. When asked about “threats to America,” she said that the biggest challenge was the establishment of a strong, well-regulated financial system that could avoid the repeated crises that we have faced. The situation in Greece may impact Fed policy. Yellen noted the potential disruptions due to a Greek collapse could spill over indirectly to our own economy.
Creating an investment strategy in this environment is a challenge where the goal is to achieve a balanced, long-term rate of return. We know that our clients have individual needs—some for immediate cash flow, some for capital purchases, and some for long-term growth. While these issues can be dealt with by allocation and anticipation of needs, the concept that ties this approach together is ownership of quality assets. That translates to highly rated bonds, dividend-paying stocks, and investments in both indexes and the top actively managed funds. This is not without risk and, while we have had disappointments, we diligently try to limit exposure to the riskiest markets while avoiding unnecessarily complex strategies that are difficult to understand. —Jerry McQueen