Investment Insights: Greek Debt and Global Market Turmoil,  June 2010

Brett Hammond, Chief Investment Strategist
Brett Hammond is a managing director and Chief Investment Strategist for TIAA-CREF Asset Management. His group is responsible for asset allocation modeling and institutional advising, economic and market commentary, and investment product and portfolio research.

• Greece has made the headlines, but debt is a widespread problem in Europe.
• Together, Greece, Portugal, Spain, Italy and Ireland owe about $2.6 trillion to public and private creditors.
• Global investors, however, are more worried about the U.S. recovery.
• Stimulus spending is peaking—can consumer spending take its place?
• Markets will watch closely to see how governments and consumers spend in the months ahead.

Over the last weeks, stock markets around the world have returned to volatility, rapidly losing much of the gains they made so far this year and during the last part of 2009. We have also seen another flight to quality as investors have bid up the prices of U.S. Treasuries and bid down yields. Many of the reasons given for the re-emergence of market turmoil have to do with Greece and the European debt crisis, with investors fearing that the Greek government's fiscal troubles will infect financial markets and economies in Europe and the United States.

First, a few facts. The economies of Portugal, Italy, Ireland, Greece, and Spain (commonly known as the PIIGS) were among the hardest hit by the recent recession and are suffering from weak economies, big government deficits and the need to make payments on sovereign debt with diminished revenues. Moreover, these countries can't adopt one of the tools often used by countries in similar circumstances – devaluing their currency – since they share that currency with 17 other European countries who are not interested in following that policy path. To assist Greece, the other European countries have pledged up to $1 trillion in loan guarantees, because, if Greece and other troubled European countries default on their debt, it could deeply affect the rest of Europe, since most of that debt is held by European banks and other institutions.

According to estimates by the Royal Bank of Scotland, Greek government debt held by European institutions totals about a half a billion dollars, but public and private debt in the troubled countries totals about $2.6 trillion, well beyond the bounds of any loan guarantees. Combined with the reluctance of Greek citizens to accept austerity measures, the scale of the problem is making investors around the world nervous about the prospects for defaults by Greece and its banks, as well as by other countries and by European banks holding all that public and private debt. The basic worry, which is not often explicitly expressed, is that country and bank defaults could plunge the world back into the financial crisis that gripped us in 2008.

The stock market meltdown in 2008 was largely due to a credit crisis – too much borrowing by banks, hedge funds, other financial firms, and individuals nearly led to a collapse of the financial system. Are we seeing a repeat of that in Europe right now? It is true that debt is playing a big role in Europe. Greece, Spain, Portugal, Italy and Ireland are running government deficits and are building up national debt while their economies have shrunk. This is making it hard for these countries, especially Greece, to make the payments on their debt. So there is a real possibility that Greece and perhaps one or more other countries will default on their debt.

There is a big difference, though, between Greece and Lehman Brothers, the firm that collapsed in 2008 and helped trigger the U.S. credit crisis. Countries can default, but they can't go out of business. Greece will still have an economy and its citizens will pay taxes, albeit that growth may be slower and tax revenues may drop. So we can be confident that Greece will still exist and will be able to pay off some of its debt. In addition, of the 22 countries in the eurozone, most are quite strong – Germany, France, Netherlands, etc. They do have the ability to assist the countries that aren't doing as well and to cushion the credit crisis in Greece to some extent.

So does that mean the immediate future is rosy for Europe and European companies? No. The current crisis points up the challenges of a single currency – the euro – used across 22 countries, let's say compared to the dollar and the 50 states. The benefits of the euro, however, are important ones. Trading, manufacturing, service provision, transactions, accounting and a host of other things are much easier and cheaper for Europeans without the need to cope with 22 different currencies, each fluctuating at different rates.

This is also true of the United States, with its dollar. But here we have a strong central government that can step in during a crisis to increase spending temporarily and manage interest rates. Although Europe has a central bank, it can't so directly affect Greek interest rates by tying them to pan-European interest rates. So the interest rates charged by Greek banks can skyrocket while German rates remain low. Also, as we have seen, without a powerful central government, direct aid to an ailing nation requires dozens of countries to arrive at separately negotiated agreements.

We've seen that it can be difficult to get Congress to pass a fiscal stimulus package that includes aid to the states, but it is far more difficult to get the legislatures of 22 countries to agree on aid packages for one or two nations and then follow through on delivering the aid. This is one of the main challenges Europe is facing at the moment. Individual European countries have offered the promise of loan guarantees, but that's a weaker backstop than actual spending. In addition, some investors fear that, if loan guarantees are actually needed, some countries that have promised them may be reluctant to actually follow through.

Countries in Europe lack another common mechanism used in a financial crisis, namely currency devaluation. Think of Mexico in the 1990s and Argentina more recently. In Europe a single country can't devalue its currency since the currency covers all of the countries. Instead, in a crisis, that country must try to lower prices and wages, things that are extremely difficult to do compared to currency devaluation.

As the European debt crisis continues, it raises other questions as well. Will China stop trading with Europe? Some people have worried that the fall in the value of the euro, which makes imports to Europe from China and other countries more expensive and investments held by foreigners less valuable to them, will cause China to back away from trading with and investing in Europe. The result could be further pressure on European economies and financial markets. There is no doubt that exports to Europe from all major countries will be more expensive and will surely suffer. However, the price of European goods and services imported by China, the United States and other countries will fall and be more attractive. This will serve to bolster European companies and countries.

What about investing in Europe? Returns on current investments by foreigners in Europe have suffered because of the decline of the euro. However, new investments in Europe appear attractive for the same reason. A cheap euro makes investments in Europe cheaper.

Interestingly, despite or perhaps even because of Europe's problems, there may be some good investment opportunities in Europe.

In addition, there is a strong possibility that Europe or some of the countries there will experience deflation or falling prices. European governments and the European Central Bank are traditionally more sensitive to inflation than the United States. and tend to tolerate higher interest rates and unemployment than we do. If the European Central Bank and European governments believe that deflation is more likely than inflation, they may be inclined to lower interest rates, increase the money supply, and take other actions to stimulate economic growth. This would be nearly unprecedented in Europe, but it would be similar to what has happened here. in the past year: an economic recovery led by government spending and low interest rates. Taken together, these factors could make European companies, especially those with significant sales outside Europe, attractive in 2010.

But what about global stocks? With all of the uncertainty about Europe and its banks, markets in Europe, Asia and the United States have lost recent gains and appear poised for a period of uncertainty and turmoil. Despite the news from Europe, the basic problem here is that the future of economic recovery is uncertain, regardless of Greece and its problems. Government fiscal stimulus is peaking right about now and pledges to cut public budgets at the state and national levels are highly visible. This means that federal aid to the states and other spending measures are likely to fade, removing an impetus for further economic growth. Unless the U.S. consumer steps up to replace government spending as the engine of economic growth, prospects for the U.S. economy in the latter part of 2010 and into 2011 are less rosy than the current estimated GDP growth rate of about 4% would indicate.

Stock markets tend to anticipate future corporate earnings and economic growth. Right now, it isn't just Greece that should be a worry. Investors are concerned, in the short run, about the prospects for another debt-led global financial crisis. They are also worried about less-than-robust economic growth, regardless of whether a financial crisis occurs. So watch for ways in which the Greek crisis may be resolved, but also watch consumer spending and future fiscal stimulus plans for signs of where the investment markets are going.