Euro Collapse

The prime fear in the markets is that if, or perhaps more appropriately, when, Greece abandons the Euro, totally defaults on its debt, and slides off into oblivion, it may set off a chain reaction. If Greece is able to get away with not paying back the money it borrowed and the sky does not fall in on their heads, why should the good people of Portugal, Ireland, Italy, Belgium, Spain, and even France suffer from government imposed austerity in order to pay back their debts?

Greece will definitely have a hard time either way. Their economy is not particularly viable as it stands. They import a lot more than they export, and if they try to pay back their debts, they are facing a depression level economy for the next decade or more. If they bail out, no one will loan them money to finance their purchases, but (and this is important) tourists will flock to Greece where their dollars and Euros will buy a LOT more stuff and luxury hotel rooms.

As an example, Greek olive oil will suddenly be half the price it was before. Exports will surge, as will tourist dollars and Euros. If it were to only go that far, Greece would probably be the better for it. No one really expects the Greeks to pay off their debt as it is. Making it a fiscal reality would just be to recognize that reality.

The challenge will come as the Italians suddenly find they cannot sell their olive oil unless they take a loss because the Greek olive oil is so cheap. The Italians also owe a lot of money, mainly to the Germans. They are experiencing the “austerity” advocated by those same Germans in order to pay back those German Euros. In order to pay back their loans though, they need to be able to sell their products and attract tourists. If the Greeks suddenly have a pricing edge, it may make paying back the Italian debt very nearly impossible.

Greek’s economy is not really big enough to upset the proverbial apple cart, but democracy being what it is, it would not be unreasonable for the people of Spain, who are also suffering greatly to pay back the Germans, to decide to follow suit. Spain is facing 30% unemployment and the potential melt-down of its entire banking system. To be able to wipe the books clean and start over would give them a fighting chance to recover.

Spain, by the way, has a very favorable government debt level. The problem there is that the banks loaned far, far too much money out to build houses. There are currently a significantly larger number of houses in Spain than there are families to live in them. The same borrow and build mania that hit us hit them as well. The same real estate insanity took every major bank in Ireland down too. The Irish government rescued the banks to avoid a complete financial collapse and now owes more than it can reasonably pay. The Spanish will almost certainly find themselves in that position in short order.

The problem is that if Spain decides to pull the plug on the Euro, Portugal, and Italy will almost be forced to follow. Ireland would go out the door as well, not because they could not sell olive oil (they don’t grow olives) but because if all those other countries can shirk their debts, why should the Irish suffer to pay theirs?

The Problem With Greed

Remember the cornerstone of the Greek advantage in leaving the Eurozone and readopting the Drachma? It was that by devaluing their currency and economy they would be able to sell olive oil and attract tourists. That strategy of “beggar thy neighbor” only works as long as Greece is the only one doing it. If Italy, Spain, Portugal, and Ireland all do the same thing, then all they have done is make imports of things like food, cars, oil, medicine, and other things everyone needs unbearably expensive. It also means that a lot of people will be out of work who used to make a living selling those things.

On the other side of the fence, the more prosperous countries like Germany and the Scandinavian members of the Eurozone will be hit by a double-whammy! First, the euros loaned to countries defaulting on their debts will be lost, and second, much of what the debtor countries, or more accurately their citizens, did with that borrowed money was to purchase goods and services from the same countries that loaned them the money. The more prosperous and lower debt countries, mainly in north and central Europe are already feeling the pinch as their economies sink into recession.

In the event of a rush for the exit, were that to follow a “Grexit,” Europe would almost certainly experience a severe recession. Prediction beyond that point verges on speculation, but there is a general consensus that at least the more stable countries in the central and northern part of the current Eurozone would very likely form a more centralized union.

The Long View

In the midst of the many negatives we should not forget that the possibility exists that Europe may yet wake up and choose to avoid the very unpleasant results of a Grexit, and the possible ensuing disintegration of the Eurozone. It will take the nations of the Eurozone surrendering a significant portion of their sovereign “rights” and becoming far more like a state here in the United States than a league of “nation-states” as they are today.

Historically, nations have surrendered their sovereignty only when faced by disaster as the alternative. Here in the United States we elected to form a constitutional republic only after facing a collapse of the Continental Dollar and the very real intent of Great Britain to reclaim her 13 rebellious colonies by military force.

Europe is facing the threat of a Euro collapse and the commercial and fiscal pain that will come from that disintegration, but that will not be a new event in history. There have been leagues of nations in Europe before, and they have all collapsed. It took the dominance and later the threat of Napoleonic France to drive what is today Germany into a single nation. Even with all the elements aligned, it still took over a half century and several wars for modern Germany to emerge as a single nation from the dozens of monarchies and city-states that previously existed. Once Germany emerged it promptly became a threat to the same neighbors that it feared. Three major wars later Germany was still divided into three nations, West Germany, East Germany, and Austria.

The many sovereign states that previously existed all spoke the same language. Still, German “unification” ultimately took from about 1814 until 1991 to stabilize into merely two German nations. Here in the United States it took us from 1776 until 1864 and a full fledged civil war to finally “form a more perfect union.”

There is hope that the Europeans can read their history and grasp that they can either unite or face a very unpleasant future. Unfortunately, the indicators are not favorable.  Even as I write this, the citizens of Ireland are voting on whether or not to agree to a stiff austerity treaty that would result in hard times for years to come, but would grant them the right to be rescued from a complete collapse as they paid down their staggering debt load. If they vote “no,” that decision may mark the beginning of the end of the Eurozone as we know it.

So What Does this Mean to Your Portfolio?

While there may be a panic if and/or when the Euro finally starts to come apart, that is not something to fear. Economic events that we all collectively are afraid of generally are not any real danger. We Americans are pretty good at preparing for and hedging against the dangers we see coming.

The Federal Reserve, Comptroller of the Currency, and the FDIC have been making the rounds of the banks, demanding that each institution have a viable and tested plan to deal with the collapse of the Euro. In Europe, the European Central Banks and the major creditor nations have drawn up plans to deal with and recover from the breakup.

A collapse of the European monetary union as we know it would be a severely deflationary event in that a lot of money will simply disappear. An institution or person to whom one of the defaulting nations owed money will suddenly see the value of that debt or loan, drop by 90% or more. That means that banks will abruptly see billions of Euro’s worth of assets simply vanish. 

It is sometimes hard to remember that a deposit in a bank is in fact aloan to that bank. If the bank is in a country that changes currencies, and the new currency is only worth a fraction of the previous one, then a depositor will see a loss of purchasing power equal to the difference. The vaporization of so much purchasing power will indeed tend to create serious deflation. In deflation, there is an actual shortage of money, causing jobs to be lost and generally leading to an economic depression.

Depressions in both Europe and the United States have most often ended in major wars. The money created to fund the war effort refilled the economic coffers and got things going again. Economists, including our own Ben Bernanke, have suggested that refilling the coffers from the central bank early on is probably more efficient than waiting for a major war to do the same thing.

The European Central Bank, The Bank of England, and the U.S. Federal Reserve Board have hinted that in the event of a serious default crisis in the Euro, they would inject large amounts of money into the dollar/Euro/Pound system to prevent a “melt-down.” At the same time banks and corporations across northern Europe and in the United States have stockpiled large cash holdings to cushion against the potential losses from a partial or total breakup of the Eurozone.

Yes, there will likely be a short-term market panic, but once investors realize that the reserves are available and have been deployed it will dawn on them that the dollar just lost its only likely competitor in the world. Money will come in from near and far to find safety in dollar denominated investments. More importantly, the ensuing crisis will mark the end of uncertainty. The range of possibilities from there are nearly all positive, and some are very positive!

2013: The Beginning of the Great Recovery

I have said and written this before, but 2013 is looking more and more like the beginning of an American and global recovery that will roll into an economic boom unlike any we have seen in my lifetime. Interest rates, and thereby borrowing costs are at record lows. Consumer debt has declined to a level that is actually below long-term norms. The housing market appears to be on the verge of stabilizing. Last but not least, the United States Congress, following an end of the cyclical collective insanity we call a “Presidential Election,” is likely to get down to business and actually start doing something positive. That last item is the only one really in question, but an economic boom is not dependent on sanity in the halls of state in our nation. We, in the end, have a relatively stable Constitutional system. We are a nation of laws, not of men’s passions.

I will reiterate here what I have written before. Barring some absolutely unknown event, such as a natural disaster of epic proportions, we are primed and poised for economic good times. There have been more than a few points in history like the ones we are experiencing now. Every one has marked the end of a slump and the beginning of prosperity that eventually carries us collectively to levels beyond our dreams. A decade from now we will look back and wonder what we were afraid of.

It is then that we should begin to be concerned about the future. Today though, the opportunities abound. Those who remain invested in a well diversified portfolio of publicly traded and financially profitable companies are very, very likely to see a growth in their wealth not unlike that which occurred from 1986 to 2000. Over that 14 year period, the broad stock market total return averaged over 17% per year. After inflation is subtracted, the real return averaged over 12% per, doubling an investor’s money about every six years. The future is always uncertain, but history is our best guide. History suggests that things will look a lot brighter in the not very distant future. $$$

Real Concerns

While the Euro crisis grabs the headlines, there are some real threats we should be avoiding.

 Like the man who, to defend himself from the “snake” in his path, picked up a stick that turned out to be a real snake, there is a tendency to rush from perceived danger to very real danger when we are scared. What you see above is the real, inflation adjusted, total return of $250,000 in the Morningstar Long-Term Bond Category from July 1977 though July of 1982. The original $250,000 investment value would have declined to about $165,000 by October of 1981,including the assumed value of all interest reinvested! That decline in value of about 34% occurred despite an average interest rate of about 12% per year on those bonds. If the bondholder had been spending the interest, then the decline would have been over 50%! (See note 2.)

This short five year period was at the tail end of a decade of rising interest rates that started in the early 1970s. The way investors are flocking to purchase longer term corporate and “high-yield” bonds today, one would think that they consider a scenario like the one depicted above to be an impossibility. In fact, my experience suggests that they are just blissfully unaware of history. As Jorge Santayana said so well, “Those who do not remember the past are condemned to repeat it.”

The past is not the future, but with interest rates at record lows, at some point, those rates will almost certainly rise. As they rise, bond holders will see a declining real value of their bonds in the market. At the same time the federal government will almost certainly be chopping “discretionary” spending. Much of that discretionary spending goes to state and local governments. A combination of rising interest rates and potential decreases in revenue will have a tendency to put municipal bond issuers in a bind. The other institutional set that is at risk is the insurance companies.

Muni Bonds: Is the Risk Real?

Purveyors of municipal bonds will gladly point to the last several decades as proof of safety. Yes, Orange County, California went under as did the sewer issues of Mobile, Alabama. Of course there is that small problem of Detroit, but never mind, those were just a tiny percentage of the total bonds issued. Then there is the insurance on many bonds. Unfortunately at least one major municipal bond insurance company is already bankrupt and the other two largest players are on pretty shaky ground.

Without doing a lot of research it is actually pretty easy to spot risk in a bond, municipal or otherwise. Mr. Market will tell you in a moment! According to the Financial Times, the average 10-year tax-exempt, municipal bond is yielding about 2.5%. The 10 year U.S. Treasury Note, which is the benchmark for “no-risk” is yielding about 1.59%. To put those numbers in perspective, the French 10 year note is yielding 2.36% while Spain is at 6.56%, Portugal is at 12.19%, and Greece notes are yielding 31.17%.

The bond market is effectively stating that Portugal is probably going to default within six years, Greece might make it three years, while the United States will easily be around to pay up with little or no inflation ten years into the future.

So, what does that 2.5% rate on municipal bonds mean?  The bond market is effectively saying that the average U.S. municipal bond is about 60% as risky as the Spanish notes and about 1/3 as likely to fail as Portugal. Since the odds makers are giving the Spanish about a 50/50 chance of failure, that boils down to the market stating that an investment grade municipal bond has about a one in four chance of failing or falling significantly in the next ten years.

Here is the bottom line. Inflation over the next decade is likely to be about 2.5%. That means that the average municipal bond in a best case scenario with all income reinvested may break-even. That same bond, according to the interest rates assigned it by the market, has a one in four chance of being worth significantly less than was paid for it.

What Else is Risky?

Life insurance companies are bombarding me on a daily basis with offers to sell 3.5% “guaranteed” annuities. Since the surrender charge period on those annuities are often 7 to 10 years, we can logically compare them with those 10 year notes. In order to pay the agent a 4% commission and then pay out the 3.5% per year, the annuity has to yield 4% per year. The insurance company will need another 1% to stay in business, so the effective yield on that annuity will be about 5% per year. Insurance companies use bond portfolios to fund those annuities, so how risky does that make a “guaranteed interest rate” annuity?

The answer is that the rates insurance companies are promising make them about 80% as likely to fail as Spain. They, like Spain, have no FDIC or other federal insurance behind them. The market is also telling us that if you were to purchase an immediate life annuity from an insurance company, you have about a 40% probability that you would have an unpleasant surprise at some point in the future.

How about the stock market? What are the probabilities that you will have a significant loss if you hold a diversified portfolio of stocks, and reinvest all your dividends, interest and capital gains over the next 10 years? You do have a chance of loss, about 5.9%. If you hold on another five years though, the chance of loss, based on historical returns, is effectively zero.

Lets take it another step. If you instead of just blindly using the S&P 500 Index (as I did in the last example), set up a portfolio based on Markowitz’s Efficient Frontier calculations, using Morningstar’s mutual fund categories as asset classes, what would happen? Historically, there are zero months in which you would have a loss after holding for ten years. That, of course, is why fund like the Texas Teacher’s Retirement Fund are required by law to use that method.(See note 2.)

Remember that when you are afraid it is the thing you think to be a refuge that is the most dangerous. There are no guarantees that are completely safe. The only place you can put your money that eliminates all financial risk is a bank deposit insured by the FDIC or by holding a Treasury security from issuance to maturity.

If you want a higher return than the 1.56% offered by the Treasury, then you must identify, estimate, and manage the risk. That is what portfolio management is all about.

Sincerely yours,

Jeff McClure, CFP®

Note 1: The Dow Jones Industrial Average (the “Dow”) and the Standard and Poor’s 500 Stock Index (the “S&P 500) are indexes and could not have been used as investment vehicles during the period shown. They are used to illustrate the general, broad performance characteristics of equities during the period.

Note 2: Morningstar Mutual Fund Categories are averages of the monthly total return of those mutual funds that Morningstar has determined are primarily invested in a set of securities represented by the category title. The Categories generally qualify as “asset classes” in the sense that the term is used in the works of Dr. Harry Markowitz, including his publication of “Portfolio Selection” in the March 1952 edition of The Journal of Finance for which he was a co-recepient of the Nobel Prize in Economics in 1990 and in his book by the same name. Morningstar Categories cannot be used directly as investment vehicles.