The Greek Tragedy is Societal
Greece has mismanaged its economy for decades. The Greek people are now paying a heavy price for government mismanagement. Before they entered the European Union (EU) Greece routinely devalued its currency (the drachma), thereby avoiding fiscal reforms that are vital to a sustainable economic system. As a Euro system member it no longer has this monetary option. Therefore, it has relied on creditors to fund its fiscal deficits. Creditors, fearing perpetual bailouts, have drawn the line demanding Greece get serious about fiscal reforms. Markets are nervous over the uncertainty of Greece leaving the EU and what it might mean were other countries to leave the EU.
Yet, these issues have been known since 2010; European banks have bolstered their balance sheets and reduced their Greek exposures. Economically, the overall cost of a Greece bailout is only 2% of euro-zone GDP. The broader market fear is that other troubled nations like Portugal or Spain, might also decide to leave the EU (although both have improved over the past five years and are in much better shape than Greece). During this most recent bout of turbulence, their bonds yields moved in line with other Euro nations (which means creditors are not overly concerned). As a backstop, the European Central Bank (ECB) is ready to buy bonds where needed. The tough negotiating stance adopted toward Greece, combined with very unfortunate economic impact on the Greek people, may very well serve as a deterrent to countries that might contemplate a similar path.
Asset Class Review
US interest rates rose rapidly from February lows, which put pressure on income/yield sensitive investments like REITs, MLPs, and bonds. The price of oil also took another downturn, along with most other commodities. In this quarter’s review I’ll examine these events, what they might mean, and how they impact your portfolio.
Europe’s markets have lagged the US by about 60% on a dollar basis over the past five years reflecting a weaker currency, the Greek situation, and the region’s structural problems (heavy social welfare spending and aging populations). Still, it’s no reason to avoid the region. Valuations are lower than other regions and European companies operate in a global market. Consequently, their fortunes are less reliant on their home countries.
China – Playing Catch Up or a Bubble?
Over time stock markets track their economy and corporate profits. However, they don’t move in a nice straight line. For example, in the table below you can see China’s economy expanded by 43% from 2010-2014; yet its stock market was up only 9%. Beginning in July 2014, it catapulted 110% and has recently pulled back 30% from its peak; still up some 80%. From 2010-2014, the US economy expanded just 11% yet our stock market increased 103%! History is full of these type of divergences between markets and the economy. However, markets ultimately adjust to economic reality.
Of greater concern to some analysts was the Chinese government’s attempt to stop the decline: IPOs were halted, large shareholders were forbidden from selling their shares; over 90% of Chinese stocks suspended trading; central bank backed share buying schemes were launched. Some feared that the stock market would impact the real Chinese economy. That fear doesn’t have much basis in reality. According to “The Economist” small retail investors drive 90% of daily trading; stocks accounts for just 15% of household assets. The value of the Chinese stock market is about 33% of Chinese GDP (vs. over 100% in the US and other large economies).
China has purposefully begun to shift its economy away from infrastructure and investment lead growth toward consumption. This path is more sustainable but will slow its growth. Still, China and India represent 40% of the world’s population and have economies growing at nearly 3 times the rate of the developed world. Stock markets are a bet on capitalism and ultimately reflect economic and corporate profit growth. As Asia’s economic ascent continues it’s reasonable, logical, and likely that these markets will eventually reflect their growing economic clout. However, they are still emerging markets so the road will not be without risk. For these reasons, we keep emerging market exposure for the potential growth, but only in proportion to your tolerance for risk.
Interest Rates
The 10-year US Treasury bond is a benchmark, market-driven rate that is a key determinant of various consumer and commercial interest rates (such as mortgage rates). From February 2, the 10-year rose from 1.67% to 2.4%. When rates rise this quickly and sharply, yield-type investments (REITs, MLPs, and bonds), usually see price declines as investors trade these assets for lower risk, higher paying bonds. Consequently REITs, MLPs, and bond funds, on average declined sharply by about 13%, 13%, and 3%, respectively. The price declines to REITs and MLPs is usually a short-term hit, because the factors that increase rates, also tend to drive higher real estate rents and higher commodity prices. These assets continue to pay strong dividends and over time the underlying assets should rise with the economy and inflation.
Lastly, in order to better protect bond values against rising rates, bullet bonds were purchased. These allow us to achieve diversification, institutional pricing, and to ladder bond exposures. A bond ladder is a way to roll near-term maturities to long-term maturities as they expire. This allows us to spread interest rate risk across a range of time periods, better protect principal, and avoids having to try and time the ups and downs of interest rates.
PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.
