Could the US Be the Next Greece or China?

Posted by Alex Frey (@alexhfrey )

Whether they admit it or not, most investors today have a single fear that they can't quite shake, no matter how convincing of a story they tell themselves otherwise. What wakes most investors up in the middle of the night in a sweat is the ideathat the past five years have been a financial mirage. The S&P 500 t tripling from its bottom has just been the byproduct of a bubble re-inflating, and we're soon going to go back to where we were in 2008. Nobody wants to be the sucker buying at the top. 

To address this fear, it's instructive to look at two places in the news right now that are each going through their own, albeit very different, version of a financial nightmare: Greece, and China, and to posit the question: are we really different?

The “crisis” in Greece is, by now, not a crazy event that has come out of the blue. It seems like Greece has been constantly in the news for the past several years, and the Greek crisis came to a head again in the last week. As everyone knows, Greece has an enormous government debt, and it can’t meet its payments without help from other members of the Eurozone (the Eurozone (EZ) is the group of countries within the European Union (EU) that use the Euro as their currency). If Greece can’t make its debt payments, it may be forced to leave the EZ.
Lately, each time a bailout seemed likely, world stock markets have taken a step upward, and each time it appeared that there might not be a bailout, the world stock markets have turned down. Fortunately, the most recent development is that Greece and its EU counterparts seemed to have reached an agreement. But it’s still worth considering a couple of questions: First, will this agreement really solve the problem, and second, why should the fate of a small country such as Greece have such an effect on world markets?

We should start by recalling what has happened to Greece in the last few years. In the decade prior to 2008, the Greek economy grew rapidly, but the economic crisis of 2007 showed that this was partly based on growing debt. For a time this was apparently hidden from sight by some creative bookkeeping, but in 2009 it came to public knowledge that the annual deficit was somewhere in the range from 12 to 15.7% of GNP (the exact figure is in some dispute). At that time, the total accumulated debt was about 127% of GNP. At this point, investors began to fear that Greece could not pay the debt and demanded a higher interest rate for any new bond issues. Greece could not afford to roll over its debt, and the other EZ countries were forced to provide a bailout. 

The bailout (actually, there have now been three bailouts) came with harsh terms. Greece was forced to accept austerity measures that included raising the retirement age, freezing the level of pension stipends, reducing public employee wages, reducing the minimum wage, raising various taxes, and raising fuel and electricity costs. As a result, since people had less money, they spent less, and the economy went into a steep decline. Although government spending declined, the GNP also declined by more than 25%, and unemployment climbed to more than 25%. Youth unemployment (persons under 25 years old) rose to more than 50%. Greece has been enduring a situation that is as bad as or worse than that of the U.S. during the Great Depression. Paradoxically, the accumulated debt as a fraction of GNP has actually increased because GNP has been going down. 

Greece’s use of the Euro was partly responsible for its prosperity in the run up to 2008, and it is also to a great degree responsible for the current problems. If Greece had its own currency, it could solve the problem by devaluing its currency (or letting the market devalue the currency). This would increase exports by making them cheaper and decrease imports by making them more expensive, and this would allow Greece to earn the foreign exchange needed to repay the debt. Also, to the extent that the debt was denominated in the local currency, inflation would reduce the value of the debt. This would not be painless for either Greece or its creditors. In fact, it would likely reduce the value of wages and pensions to a similar degree that the austerity program does, and it would give creditors a “haircut”, but it would bring the crisis to an end. For this reason, some economists think Greece should leave the EZ and perhaps return later after they get their house in order.
In the latest agreement, Greece stays in the EZ and accepts more austerity (more tax increases, a higher retirement age) in return of another round of bailout funds. Will this agreement end the problems? The International Monetary Fund doesn’t think so. They think the Greek debt is unmanageable and only some sort of debt write-off can bring the Greek debt problem to an end. We can’t predict how this will come out, but for the sake of the Greek people, we certainly hope that Greece works its way out of these problems.

In the meantime, we need to ask whether the Greek problem should be a major concern to investors elsewhere in the world. Greece is a relatively small country. Its GNP is about 1.5% of that of the U.S. GNP and about 0.38% of the world economy. So how can such a small country affect the world stock market? The concern is contagion. If Greece fails, people will begin to worry about other countries with high debt to GNP ratios and high budget deficits (Spain, Portugal, and Italy are often mentioned). Also, people may begin to worry about the stability of banks that have lent money to these countries. Because of these worries, banks may become reluctant to lend to one another, as they did during the Great Recession of 2008 and 2009. One can imagine a scenario where there is a sharp contraction in the available credit and a sharp rise in interest rates, which would slow economic growth or send the world economies into another recession. 

We have never claimed to be good prognosticators, but we doubt that this will occur for several reasons. First, private banks have largely unloaded their Greek debt. It is now largely held either by the European Central Bank (ECB) or by other EZ governments. That should mitigate worries about the stability of the banks. In effect, the purchase of this debt by government entities was a bailout of the banks that is already complete. Also, the ECB has started a policy of quantitative easement (buying EZ government and certain private bonds). This expands the supply of Euros, reduces interest rates, and has significantly reduced the value of the Euro against the U.S. dollar and other currencies. This helps all EZ countries, including Greece, to expand their exports and to some extent does what Greece would do if it had its own currency. We presume that the ECB would become even more aggressive in this regard if there was evidence of contagion.

So, on balance, while we feel great sympathy for the Greek people, we don’t think the Greek situation will have any significant, lasting effect on world stock markets. 

The situation with the Chinese stock market is very different. It developed very suddenly and could affect anyone with an investment in an emerging markets fund. If you are an IvyVest investor, you probably hold an emerging markets fund such as the Vanguard Emerging Markets Index Fund (ticker VWO) or the iShares Emerging Markets ETF (ticker IEMG). The VWO fund has about 28% Chinese securities and the IEMG fund has about 21%. So what has happened to Chinese stocks lately? For brevity, we will discuss only the largest of the Chinese stock exchanges, the Shanghai Stock Exchange (SSE), but a similar picture applies to the Shenzhen and Chinext exchanges. For the years from 2010 to 2014, the SSE composite index was either flat or slightly declining. In 2014, the Chinese government tried to stimulate the market by cutting margin requirements and other measures. The result was an explosion of stock prices that sent the SSE composite up by 150% in less than a year. There is evidence that small investors were going into debt to buy stocks. At this point the Chinese government tried to rein in the enthusiasm by raising margin requirements. Then suddenly, in June, the market started to drop precipitously. Between June 8 and June 29, the market gave back almost half of its recent gains. 

The reason for the sudden drop is not obvious, but valuations on the SSE had gotten quite high with price to earnings (PE) ratios in the range of 25. Valuations on the Shenzhen and Chinext exchanges were much higher. The actions and comments by the government may also have stimulated a deflation of the market. As we are writing, the Chinese government has reversed course and is trying to support the market by reducing margin requirements, ordering state agencies to buy stocks, and forbidding large stock holders from selling stocks. They also froze trading in many stocks and have still not completely lifted the freeze. Their efforts seem to be working, at least for the moment, because the Chinese stocks have risen for the last few trading days. At the moment, the Shanghai composite index has a PE ratio of about 19.5, which is actually a little less than the ratio of the Vanguard Total Stock Market Fund, which tracks all U.S. stocks. However, the PE ratios on the Shenzhen and Chinext exchanges are much higher, and they may still be overpriced. 

To us there are two lessons here. The first is an old story: it’s hard to predict the direction of markets in the short term, which is why diversification is good. The second lesson is that the Chinese market is not really a free and open market. The government tries to exercise some control over the market. Whether this is good or bad for investors is open to debate, but we certainly wouldn’t want to go “all-in” on the Chinese market. We are satisfied with having a small exposure via an emerging markets index fund. 

Finally, let's get back to the selfish question in everyone's mind: could the US be the next Greece or China? After all, both countries enjoyed many years of boom-times (like we are going through now, at least in the stock market), before they hit a period of turbulence. Also, there are, on the surface at least, parallels in both cases. 

First, like Greece, the US has been criticized for having a high level of public debt (near 100% of GDP by some accounting), which could make it susceptible to a debt crisis if investors lose confidence en masse. However the huge difference in the two countries here is that the US has a central-bank with the ability to print money in its own currency, and the U.S. debt is denominated in its own currency. Indeed, whether or not the Federal Reserve's “quantitative easing” program constitutes “printing money” or not depends on who you ask, but it did serve to keep interest-rates lower than they probably otherwise would have been, and to increase investor confidence. Any country that can print money in its own currency can avoid “defaulting” by simply doing exactly this. So the US is unlikely to be the next Greece. This doesn't mean that the U.S. can run up limitless debt, but a debt crisis in the U.S. will play out very differently and probably isn't imminent. In fact, in recent weeks the U.S. dollar has been getting stronger and interest rates on treasury bonds have been going down. 

The Chinese case is more interesting, since the recent turbulence was brought on more by a change in investor attitudes then by any real economic event. It is certainly possible that this could happen in the US as well, particularly since valuations here are also quite high by historical standards. In other words, the US stock market theoretically could fall 40% or more overnight for no other reason than investors changed their minds about how bullish they are. On the other hand, US investors do not (currently at least) seem to be borrowing as much money to bet on US stocks as Chinese investors may have been doing in China, so the fall is not likely to be so sharp since there will be less “forced selling.” Also, in the U.S.,  the government avoids direct involvement in the stock market, so it won't be contributing to instability.  

The best course is to stay diversified, and stay invested, but also to stay nimble and reactive to a changing world. IvyVest's valuation + momentum approach does this by shifting into asset-classes that have the highest expected returns, while also acknowledging that trends can both go on longer than we think, and change on a dime. If the US stock market someday does goes the way of China and suffers a coordinated fall in investor confidence, we won't be the first investors to run out the door, but our trend-based indicators should hopefully protect your portfolio from the worst of the carnage.


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By Alex Frey