The financial markets continue to be volatile as uncertainty about the European financial crisis continues to dominate the thinking of investors and traders worldwide. The problem is centered in Greece which will default on its bonds at some point in the not too distant future but the impact of that default will be felt much more widely, especially in France whose banks own a considerable amount of Greek debt.
Unless there is a substantial reserve established to allow the French banks to charge off the worthless Greek debt, they will be forced to charge off that debt to their capital accounts. If the amount of bad debt exceeds the amount of capital that they hold, the banks will be insolvent. Understanding that the French banks have relationships with American banks, that insolvency will put pressure on the financial system in the United States which it really does not need, or may not be able to handle, right now as we try to recover from the Crash of 2008.
Figure 1: Countries in the Euro Zone
Greece is the main problem, but the Italian government is under pressure as well. Italy has seen the price of that debt decline which has driven the yield to over 7% which is most unusual. That just means that instead of paying 5% interest, its borrowing cost is 40% more than that and may be the only way that the Italian government can continue to function.
Similar problems exist in Belgium, Portugal, and Ireland with France not too far behind. The total exposure to default is somewhere near 3 trillion Euros. See Figure 2.
Figure 2 shows, for example, that Greece has 25% more debt than its Gross Domestic Product which means that it is already in default. (Note: Estonia is not listed in Figure 2 as it joined the Euro Zone early in 2011.) What is a bit troubling is that the average for the Euro Zone is 84% of average GDP.
There are answers but they are not attractive. First, the German people can vote to establish a reserve for the debt of their fellow Euro Zone countries. However, getting the seventeen countries that comprise it to agree to any plan like that would be very difficult to achieve since they don’t even speak the same language.
Figure 2: Debt to GDP ratios for EU Countries
Second, Greece, Italy, and the rest can approach China about the reserve. The problem there is that China is in the middle of a housing "bubble" like we saw in the U.S. five years ago, and no one knows what impact there will be on the Chinese banks when that "bubble" bursts just as we did not know the impact on our financial system when the housing market fell apart in 2006 - 2007.
Third, the countries with debt pressure can adopt austerity programs to try to cut spending so that they can service their debt. The problem here is twofold. If the people agree to these programs, it will take a long time for them to be effective. Further, there is doubt that the people would agree to them as they have become accustomed to government support to the point of entitlement.
While those solutions are not agreeable to many, the world financial community cannot afford to let Greece completely default. There are too many interconnections with other government and other financial systems for there to be a worldwide systemic failure.
Here at home, we have felt the impact of the uncertainty in Europe. We have watched the Dow Jones Industrial Average fluctuate between 10,700 and 12,700 throughout 2011 with the return on the Dow being 3.26% since the 1st of the year. Since October 15, 2011, the Dow is up 3.88%.
Dow Jones Industrial Average, November 2010 - November 2011
When the Euro Zone announced on October 27 that there was a solution at hand, the financial markets were buoyed and they thought that the debt crisis had been averted. Since then, however, it has become apparent that the October 27 deal was not strong enough nor would it be approved by all of the countries in the Zone, so the Dow continues to "waffle" as there is nothing out there to give prices any upward momentum.
So, where should we invest? In consultation with various colleagues in the investment management business, it is best to be defensive until the Euro Zone debt crisis is resolved. That means investing in large, multinational American companies that are doing business in countries where the GDP is higher than here at home and that pay a dividend of 5% or more. We may not see any price appreciation but we will be the recipients of significant dividend income.