At a time when most asset classes from stocks to bonds look expensive, the threat of Greece leaving the eurozone has investors feeling jittery. But it’s far from the only big risk out there. John Stepek looks at the top five.
Grexit
You’re probably aware of Greece’s woes by now. In a nutshell, Greece has too much debt. Athens wants it to be cut, and it wants to ditch austerity, imposed on it in exchange for emergency help from the rest of Europe. The rest of Europe – led by Germany – has so far been reluctant to comply.
Most people still assume a deal will be made – another dollop of euro-fudge to keep the show on the road. But as Brian Dennehy of FundExpert.co.uk points out, they may have read it wrong this time.
If Greece wants to reduce its debts and abandon austerity, the quickest way to do so is to leave the eurozone. That won’t be painless, but it does mean Greece gets its sovereignty back and can print as much money as it likes. And Germany can draw a line under a festering sore, created by a nation that technically shouldn’t ever have been allowed to join the eurozone anyway.
Under this scenario, the whole negotiation is just a face-saving exercise to allow both sides to say they tried their best, but that they have to stand up for their voters’ interests. A majority of Greeks still want to keep the euro – though fewer than before the last election.
But “intransigence by the rest of Europe and the troika will create a smokescreen behind which Greece can exit… The Greek voters will sense that their government has made a reasonable proposal, rejected by the nasty Germans,” notes Dennehy. That sense of reclaiming national pride will help them endure the short-term chaos of an exit. So a “Grexit” is certainly not out of the question.
What would happen next? The optimistic scenario is that the European Central Bank prints enough money to stifle market panic, and in the short term Greece suffers enough visible economic pain to discourage Spanish voters from following suit, stopping any domino effect in its tracks. In the medium term, Greece recovers as tourists and investors flock to what is suddenly the cheapest country in Europe (and anyone who invests just after a Grexit makes a fortune). Sounds good.
But you can paint far bleaker scenarios. Say Greece leaves. Everyone hopes “contagion” can be contained. But as Lehman Brothers showed, a bank doesn’t have to be big to be important. The eurozone’s monetary plumbing is complicated – can we be sure that knocking out the entire Greek banking system wouldn’t have wider consequences? Or say Greece gets what it wants – the debt is cut and Europe goes easy on it. That’s a greenlight to other nations to vote for their own Syrizas.
Spain – led by Podemos – would be next in line for debt relief and austerity reversal. Then Italy – in short, a whole string of crises focused on much more important nations. Even the “fudge” is not necessarily a benign solution. The problem with past European fudges is that they leave the issue unresolved. We’d only end up revisiting this story yet again in another year or so.
War
Of course, a Grexit is not the only headline-grabbing worry. You’ll be hard pushed to find a time when the world has been at peace. But the surreptitious war in Ukraine, with Russian-backed rebels destabilising the government and taking territory, points to a far riskier geopolitical picture than we’ve seen since the Cold War. For example, Nato warned last week that it was forced to intercept Russian planes in European airspace more than 400 times last year – up fourfold on 2013.
The skirmishes in Ukraine themselves have so far had little tangible impact on wider markets (and Russia’s recent woes have been as much to do with falling oil prices as with sanctions). But any significant escalation would, of course, rattle markets badly.
Perhaps more subtly, a return to a more polar world would reverse many of the gains we’ve seen from globalisation in recent decades. For example, where countries and companies start to emphasise security of supply over costs, we could see a scramble for resources, and a reduction in offshoring, both of which are potentially inflationary while being bad news for global trade.
China’s slowdown
Of course, a bog standard recession – led by China’s slowdown – is also bad news for global trade. In fact, hedge fund manager Crispin Odey reckons that what we might be seeing now is “the first experience of a business cycle since 2008”. The trouble is, investors have so much faith in central bankers these days that they “do not believe we can experience such a downturn”.
Odey’s point is that “we are really at a dangerous point to try to counter the effects of a slowing China, falling commodities and emerging-market incomes, and the ultimate First World Effects… If economic activity, far from picking up, falters, then there will be a painful round of debt default.” He reckons that central bankers have effectively used up all their monetary firepower, with only weakening their currencies remaining as a viable option.
Currency war
That in turn helps to explain the current rolling currency devaluations – also known as “currency wars”. The striking chart below, from David Woo at Bank of America Merrill Lynch (and republished by David Keohane of FT Alphaville), shows that currency-market volatility is currently at its highest level in 20 years, barring two big exceptions – the Asian crisis of 1997 and the Russian bust in 1998, and the 2008 credit crunch following Lehman Brothers’ collapse.
That’s no surprise. The Swiss recently shocked markets when they stopped artificially holding the franc down against the euro. Since then, the Danes have been frantically slashing interest rates to hold the Danish krone down too, as investors bet on it strengthening.
They’re not alone in hoping to keep their currencies weak: Egypt has relaxed its own peg to the US dollar – it is now more worried about maintaining competitiveness, than about potential inflation. And you’ve got the European Central Bank and the Bank of Japan printing money to weaken the euro and yen.
Having a weaker currency helps exporters and boosts inflation. But not everyone can have a weak currency at once – currencies have to rise or fall relative to one another. And so, Woo argues, this is a zero-sum game that merely boosts foreign-exchange volatility, which in turn makes it more expensive to sell goods overseas (because of the expense of hedging against unpredictable, hefty currency movements).
To back up this view, he notes that in the past, during periods of high currency volatility, global trade has tended to slow down. That, says Odey, matters even more today, given world trade has risen “from 12% to 32% of world GNP in little over 20 years”.
If Woo is right, competitive devaluation simply erodes trust and increases trading costs – hurting economic growth. Under this scenario, you end up with a similar outcome to the 1930s – when rising trade barriers and competitive devaluations contributed to the collapse in growth.
The bond bubble bursts
However, US economist Barry Eichengreen is less gloomy. He points out on FT Alphaville that central banks are being far more proactive and experimental than in the 1930s, and that with “sufficiently aggressive monetary action and supportive fiscal steps, policy can produce results even in this environment”. But if central banks do succeed, it could leave us with our biggest problem of all – the puzzle of bond yields.
Everyone seems to be worried about deflation right now – to the point where they are willing, in many cases, to accept negative yields on bonds. In other words, assuming the bond is held to maturity, they’ll make a guaranteed loss (in nominal terms at least). There’s often an assumption that the bond market is “cleverer” than other markets. So one interpretation for these bond yields is that deflation is indeed coming.
But it’s also perfectly possible for a bubble to have formed in bonds, as Robert Shiller hints in our interview with him. There’s a good story there – we have a “new paradigm” in the form of “secular stagnation” and the “new normal” of low or no growth.
We have price-insensitive buyers – a “wall of money” in the form of central-bank money printing and forced buying by banks requiring “safe” assets.
And yet, while we are seeing mild deflation in the eurozone, and disinflation in many other areas, there’s no guarantee that this will continue. The US just reported its strongest wage growth in six years in a very healthy employment report for January. In the UK, David Cameron is putting pressure on businesses to drive through pay rises too. And central banks in most major economies are hellbent on creating inflation.
Inflation is toxic for bonds, and all the more damaging when they’re as highly priced as they are now. Make no bones about it – a “disorderly” sell-off in the bond market could be brutal. In previous bond-market crashes, investors have been compensated by high yields – losing 10% of your capital value in a year isn’t as painful when you’ve received a coupon payment of 7% that same year.
But dropping 10% is a lot worse when your yield was already negative and you had considered your investment “safe”. Moreover, crashing bond prices would drive up interest rates. For a world that’s still very heavily indebted, as McKinsey has pointed out, that could be disastrous for everyone from consumers to companies.
Let’s be careful out there
It’s a gloomy road map we’ve laid out – and maybe it won’t all come true. But if it does, how can you safeguard yourself? For more on what you might want to buy, David C Stevenson (usually a bullish sort of fellow) has ideas on protecting your portfolio from a nasty crash.