In addition to concerns about their own nation's financial situation, many Americans are worried that Europe's debt woes will spill onto U.S. shores
In addition to concerns about their own nation's financial situation, many Americans are worried that Europe's debt woes will spill onto U.S. shores. Fortunately, U.S. financial institutions' direct exposure to the problem credits in Europe is limited. But their indirect exposure could result in credit dislocations. As we witnessed with the problems in the U.S. residential-mortgage market, national problems can turn quickly into a global credit crisis, and sovereign-debt problems could follow a similar path.
If that were to happen, the only safe havens for U.S. financial advisers and their clients would be Treasuries and the dollar. There aren't many alternatives.
The European debt crisis, along with the debt ceiling debate in the United States, has put downward pressure on equity valuations. Although U.S. corporations are generating significant cash flow and strong earnings growth, the bottom-up strength in corporate profits largely has been ignored as governments attempt to find a solution to the sovereign-debt issue.
In fact, we continue to forecast an economic expansion that will further benefit corporate-profit growth, and that equities are likely to face reduced head winds in the second half this year.
Still, the debt situation in both Europe and the United States overshadows the mild improvement on the economic front.
The lack of a plan by strong European governments to assist their weaker siblings and prevent an outright default by Greece will have a direct impact on European banks. For U.S. advisers and investors, the greatest risk would be to hold money market funds that haven't taken steps to decrease their holdings of European bank securities.
Disruption of the European debt market would continue to strengthen U.S. Treasury bonds and German bunds as investors seek safety.
Other U.S. fixed-income investments — high-grade corporates, high-yield and municipals, for example — would be less affected from a credit standpoint, except that a dislocation in the economy would suggest slower economic growth and lower inflationary concerns, which would favor high-grade credits and bonds in general.
Should the Europeans come together to prevent a disorderly default of Greece and a related bank crisis, the attractiveness of U.S. Treasuries and German bunds would decline.
Of course, the problems in Europe stem from the unusual nature of the European Monetary Union.
By design, it isn't equipped to handle large differences in economic efficiency and competitiveness. Having a common monetary policy and a common external exchange rate — but leaving the task of economic and fiscal policy to independent member states — hasn't worked out.
For the EMU to work, Europe would need both a much higher degree of economic and fiscal coordination, which would require a transfer of sovereignty to Brussels, and some sort of transfer payments.
Whether or not that happens, the core European countries with strong economies, such as Germany, will have to support Europe's peripheral countries. And that involves addressing certain legal questions as well as mustering the political will to make it happen.
MONETARY UNION
Although the direct costs of such a European “Marshall Plan” and an associated bailout would be massive, the costs of not doing so would be substantially higher. Monetary union is the latest step in a process that started after World War II to make the continent peaceful and prosperous.
A breakdown of the eurozone isn't in anyone's best interests.
For the Germans, a return to the deutsche mark inevitably would lead to substantial currency appreciation, eradicating overnight the gains in competitiveness it has taken over a decade to achieve.
The currencies of weaker countries — Greece and Portugal, for example — would depreciate, supporting their competitiveness but lowering the purchasing power of private households, which would have to pay for oil and manufactured goods in weak drachmas or escudos.
There is also the problem of markets' effectively pricing the debt of nations such as Greece and Portugal under the microscope.
Unlike corporate debt, where an analyst may develop a good sense of asset recovery in the event of a bankruptcy, assessing recoveries at the sovereign level is very difficult. After all, as the running quip in Europe goes, finding a buyer for the Acropolis isn't easy.
In the absence of empirical and reliable data, there is clearly a lot of emotion driving the pricing of various European sovereign bonds. Investors seem to be despondent, judging by the large swings in bond spreads, as well as the uptick in credit default swaps.
The consistently pessimistic view of major ratings agencies is doing nothing to help clear the air.
ITALIAN BONDS
Given the environment, it makes sense to stay away from Greek bonds for the foreseeable future.
However, other areas of the debt market, such as Italian bonds, are looking more favorable, relative to the offerings of their Southern European cousins. Unlike Greece and other peripheral markets, Italy is actually running at a primary budget surplus, its net foreign debt to gross domestic product is relatively low, its current account deficit is modest by European standards and, unlike in Spain, there is little evidence of a housing or credit bubble.
Concurrently, among the beneficiaries of the continuing concerns and the resulting pressure on the euro exchange rate will be major European exporting countries, whose products are sold to American and Asian customers. The recent slippage in the euro relative to the dollar — after an appreciation of nearly 25% from June 2010 to April — has been good news to Europe's more export-intensive economies, particularly Germany.
Given the interconnected nature of the global economy, it is understandable that U.S. investors and their advisers are skittish about the developments in Europe. But given the level of negativity already priced into financial instruments and the likelihood that some workable path will be developed leading Europe and the U.S. away from the brink, it is quite possible that the future may turn out brighter than equity and credit markets might indicate.
Asoka Woehrmann is chief investment officer of DWS Investments.
