December 9, 2011

Sovereign Debt: Don't Overthink the Eurozone Crisis

By Gregg Wolper for Morningstar

It's hard to avoid the daily updates on the crisis in Europe. The financial troubles once concentrated in Greece and Ireland have broadened in scope, raising deeper questions and prompting gloomy predictions. Some wonder whether the euro can survive. Others think it will, but only at the cost of deep and lasting recessions in many European countries.

Though optimism occasionally peeks through, sending stock markets higher for a few days, the headlines, columns, and political pronouncements usually sound notes of alarm. In this climate, it wouldn't be surprising if investors contemplated taking action. If the eurozone is in danger of collapse, perhaps it would be best to get out of the way.

Such thoughts are understandable. The situation carries much risk and uncertainty. But investors should be careful before making a move. Identifying the right areas to avoid is easier said than done. Even if one decides correctly on that score, the situation can change rapidly, and a seemingly safe haven can itself come under fire. Moreover, the areas being shunned can recover quickly, and when they do, investors who headed for the sidelines can be left behind.

The Europe Angle

It's not hard to locate the countries and securities most at risk. But the stocks and bonds of Greece, Ireland, and Portugal have already suffered steep declines, and the overwhelming majority of international funds devoted only a tiny portion of assets to those countries in the first place. As time has passed, though, worries have engulfed a variety of other targets. Spain found itself the centre of attention, then Italy, then those banks throughout the region thought to have the most exposure to the danger areas. Even German government bonds have been hit.

This complicates matters for those wishing to take evasive action. Avoiding Greece is one thing. Trying to avoid all of Europe, or even just the eurozone, is another matter. And that is not so easy to do: a large portion of the assets of global equity funds are often invested in Europe. Avoiding Europe would mean selling all your broad global equity funds--not just those focused on Europe--or trying to find one with an exceptionally low stake in Europe or the eurozone and hoping that fund's strategy, costs, and other features appeals to you. Taking these moves would entail much research, could trigger tax consequences or other costs, and might not even get you out of the line of fire.

The Targets Expand

Investors who want to take money out of Europe but keep it in stock funds face difficult decisions. Redirecting that money to funds that focus on the United States is one option. But even though the economy of the United States is holding up better than those of many European nations, it is hardly thriving. More to the point, most American firms of any size do a significant amount of business in Europe. If Europe's troubles deepen, the companies in a U.S. fund will hardly emerge unscathed.
Shifting the assets to emerging markets is another alternative. But aside from Europe, two areas currently of most concern to globally minded investors are China and India, both of which are struggling with the threat of slowing growth combined with rising inflation. In China's case in particular, a slowdown would have effects on other emerging markets. For example, Brazil counts China as a major trading partner.

China, India, and Brazil combined make up about 37% of assets of the typical diversified emerging-markets fund, and that doesn't include directly related markets such as Hong Kong and Taiwan. Even if the long-term outlook for China and India remains positive, investors trying to skate away from the current roadblocks in Europe could run into others in emerging-markets funds.

Looking at the Choices

Of course, there are other options. Bonds come immediately to mind. Investors also could move money to cash or gold or real estate or other commodities. Given the vast array of narrowly focused exchange-traded funds that have appeared in recent years, the possibilities are almost unlimited. One could even try to benefit from problems by betting against them, through short positions in securities you expect to hit turbulence or with ETFs or conventional funds that would offer the same effect.

In some circumstances, bond markets might be expected to provide a haven from stock-market turbulence. But in this case, with debt concerns a central issue, that can't be taken for granted. Moreover, to succeed with any of these techniques, investors would have to make multiple decisions correctly: when to sell, when to get back in, and which securities to buy or discard on each occasion. Even if one gets the timing right, the chosen securities might not behave as expected. For instance, gold has regularly moved in the opposite direction of stocks in the turmoil of the past few years, but recently that pattern has become less consistent.

Conclusion

This doesn't mean investors must sit still. If your current allocations or fund choices are causing you undue stress, it might be appropriate to make changes. For example, a portion of the money in stock funds (global or otherwise) could be moved to cash, which is the option most likely to hold up well in a stock and/or bond downturn. If most of one's money is devoted to just one or two funds, some of it could be shifted into other funds with different strategies for the sake of diversification.

It's critical, though, to remember that even conservative steps carry their own risks. Money sitting in cash, for example, should be out of harm's way, but it won't earn much in the way of interest and won't participate in any rebound in the stock or bond markets. Certain securities--perhaps domestically focused companies or consumer goods firms--might hold up well even if conditions worsen overseas. The trade-off is that these, too, will likely lag if and when a rebound occurs.

In short, it's understandable that investors may want to take actions specially aimed at avoiding the consequences of a further deterioration in the eurozone. But this would be anything but a simple process, and success is certainly not guaranteed.

Courtesy Gregg Wolper at Morningstar (via QFINANCE, EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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