While the U.S. stock market finished the first half of the year with remarkably low volatility, the rest of the world seems to have gone crazy. Greece, Puerto Rico and China have all been very much in the news, making investors sit up and take notice. What effect might the debt crises in Greece and Puerto Rico, and the downturn in the Chinese stock market, have on investments globally?
In and of themselves, the effect of each of these events on the U.S. is minor. The tricky part is assessing the impact on investor psychology globally. A lot of financial crises begin with a debt problem of some sort and there is always the possibility of unknown unknowns (to borrow from Donald Rumsfeld) leading to a domino effect. European banks having credit exposure to the Greek banking system that nobody knows about yet could be one of these potential dominos. I think that's unlikely, but that is certainly part of the reason why the markets are reacting substantially to the news from Greece.
Greece and the Euro
One thing I can say definitively is that the next few years are going to be very painful for the Greeks regardless of the outcome of the current crisis. If there is a "Grexit," their standard of living is going to decline substantially, and, for anybody traveling outside of Greece using the hypothetical "new drachma" as their asset, it's going to be incredibly expensive for them.
When countries with their own currencies run into financial distress, the exchange rate with others provides a self-correcting mechanism. Currency tends to weaken so countries are able to export more and it's made cheaper for tourists to visit. That sort of self-correcting mechanism isn't available when a country, like Greece, has a common currency with Germany and France.
The idea that Greece will leave the euro is still speculation at this point. There's a part of the market that feels the recent vote was just one more step in Greece's negotiating tactics to get more debt relief. But I think Germany and France are going to have difficulty agreeing to Greek demands. There are other countries in the Eurozone who have large debt burdens. What's to stop Portugal from asking for debt relief, holding a vote and then playing brinksmanship with Germany and France?
With the election, the odds are moving more in favor of a Greek exit from the euro. Long term, this would probably support the euro as the most fiscally undisciplined country exits, though in the short term it could create some weakness just from the headline news. Removing Greece from the mix though won't solve all the Eurozone issues apparent in countries like Spain, Italy and Portugal. With high unemployment rates in these countries, well north of 20% in Spain, I don't see the euro becoming significantly stronger any time soon. My base forecast would suggest range-bound trading for the euro during the next few years.
Puerto Rico is Not the Same as Greece, Except …
Unlike Greece, Puerto Rico is going to hit the pocketbook of many high-net-worth Americans, simply because many of them hold Puerto Rican municipal bonds, which have had very attractive yields. That said, I think Puerto Rico is much less prone to create any type of widespread "contagion." I'm still optimistic that there may be a positive resolution for the general obligation debt from Puerto Rico, which is constitutionally protected and is part of the Puerto Rico Sales Tax Financing Corporation (known by its Spanish acronym, COFINA) sales tax revenue bonds. There's plenty of cash behind the sales tax revenues to cover the debt service burden on the COFINA bonds, but the problem is that there's a lot of debt elsewhere. Governor Alejandro García Padilla recently suggested that all of Puerto Rico's debt may need to be bundled together so everybody would have to take a hit. It isn't just the Electric Power Authority or the pensioners; the governor's comments brought GO and COFINA debt into the mix.
There is one similarity between Greece and Puerto Rico. The fact of the matter is, if people paid their fair share of taxes in both countries, they wouldn't be in the predicament that they're in today. Puerto Rico would have budget surpluses if it could only collect the taxes it is due. There are a lot of reasons behind this inability to collect taxes, but one of the biggest is that people just aren't paying them.
Is a "Greek Contagion" Possible?
The Federal Reserve appears on pace to begin tightening in the third or fourth quarter of this year. Such changes in monetary policy from the world's reserve currency Central Bank tend to expose these sorts of over-levered situations. Our economic policy probably has a bigger effect on Greece than Greece is having on us.
Are Portugal, Spain or Italy at risk? I don't think any country in Europe beyond Greece is an immediate concern. In 2012, it was a much scarier situation when many of these countries were faced with super-high borrowing costs. They were very highly levered, and Spain and Italy were facing a borrowing cost of 8-10%. Since then, the ECB has been successful in managing the de-leveraging process, using the playbook of the U.S. There are a lot of critics of Quantitative Easing (QE), but the U.S. downturn following 2008 was shorter-lived and the de-leveraging process was less painful for the overall economy.
Humpty Dumpty and the "Great Fall of China"
China is a difficult situation among the three to handicap for me. Despite all of China's moves towards capitalism, the government manages its economy and is trying to pick winners and losers. China has more resources at its disposal to handle pockets of problems. What's happening in China doesn't appear to be a debt crisis, but they are on the brink of a crisis of confidence in the government's ability to manage outcomes and to manage the markets. The government has moved aggressively in response to the selloff within the equity market, but it hasn't had much of an impact so far.
China has transitioned from a real estate bubble into more of an equity bubble. Real estate bubbles are less newsworthy, maybe because real estate is tougher to mark-to-market every day, whereas a stock market gives you instant feedback. One of the more troubling pieces of information that has emerged from this selloff is that certain borrowers are putting up real estate as collateral for their equity margin accounts. That sounds like a recipe for disaster!
History has shown again and again that managed economies don't end well. Those "unknown unknowns" will get you if you're trying to run a planned economy. Still, China has had a relatively successful track record with this, and I'm certainly not the first to question China's managed economy.
On a secular basis, the growing middle class in China will only enhance China's status in the world as an economic powerhouse. However, that is more of a longer-term phenomenon as opposed to something that may be problematic in the short term. It does appear as though, for the first time, China is experiencing a significant economic downturn that could create social unrest. If the stock market slide affects the wealth, spending power and psychology of the Chinese middle class, that might be cause for concern. The potential for China to be a forced seller of its U.S. Treasury bond holdings could be a risk for fixed income investors and could impact growth prospects domestically as borrowing costs increase.
Over the long term, the China story still makes sense to me. My perspective is that there will be a gradual shift in economic status and power away from the U.S. towards Asia, and China is the biggest part of that equation. I'm not quite ready to label China a "bubble" at this point.
My Take on the Investment Climate
My investment thesis is that you have to pick your spots for where you will search for higher-income or higher-yielding investments. I think there are segments of the U.S. market that offer attractive opportunities. In the world of corporate bonds, in particular, I am staying up in quality and "keeping my powder dry" for any opportunities presented by corrections in the market. There have been multiple stresses in the financial markets this year, but none have been sustained. Certainly, nothing has created a huge buying opportunity on higher-yielding assets in the corporate bond market. I'm staying up in quality and exposure while looking for the opportunity when it arises in a selloff in risk assets.
Looking beyond Greece, Puerto Rico and China, the big concern on my radar is the energy space. There's been weakness in oil prices, and I think that's partially connected to what's going on across the globe as people downgrade the growth prospects in China. Energy is a sector that needs to be watched. If we get below $50 a barrel again on oil, it could have a material impact on valuation in the high-yield market due to its high exposure to energy-related companies.
