No Easy Answers for the Euro Zone

Until recently, the risk of another acute financial crisis similar to the bankruptcy of Lehman Brothers seemed minimal. But the failure of Europe's leaders to aggressively address Greece's financial problems has allowed the strains to spread throughout the euro-zone. European bankers have admitted that a Greek default (or even revaluing Greek bonds at their market prices) might wipe out all of their equity ... and then some. Governments once again have to step in to support their banks, including Dexia, a lender that was bailed out three years ago but which is now weighed down by Greek, Spanish and Italian debt. The amount of money parked at the European Central Bank (ECB) has risen to 15-month highs as banks refrain from lending to each other as the result of these concerns.

Some progress is being made...

Will the challenges of 2011 be allowed to cause another crisis like 2008? In any sensible world, it should not. European policymakers should surely not repeat the mistakes of American leaders in 2008, letting a big financial institution collapse. The investments in the crosshairs this time – sovereign debt – are far easier to value and support than the securitized subprime mortgages at the heart of the last crisis.

The problem this time is that an effective response depends upon a less cohesive European political and financial structure to carry it out. The European debt crisis has been rumbling for 18 months with astoundingly little progress. Markets had hoped that the series of meetings at the end of October would deliver a comprehensive program of measures to address the European financial crisis:

  1. bank recapitalizations,
  2. a more aggressive reduction (of 50%) on Greek government debt,
  3. an insurance program to guarantee the first loss on sovereign debt underwritten by the European Financial Stability Facility, and
  4. announcements of institutional reforms to Euro area governance.

Despite the market rally on news of a deal, closer inspection revealed more questions than answers. The result could be the worst of all outcomes: more uncertainty for banks that hold Greek debt and more counterproductive austerity for the battered Greek economy.

...but the current steps are unlikely to "solve" the problems.

While these measures are needed, they will likely not resolve the current financial tensions and political impasse. Recapitalizations will likely address investors' near-term concerns about the strength of European banks, but no amount of recapitalization would be enough to protect banks from a cascade of euro-zone defaults. It seems clear that nothing matters more than avoiding the spread of default from Greece to Spain and Italy, but the ECB seems unwilling to respond. In 2008, governments were credible backstops for their banks and the Fed was creative and persistent in its efforts to instill confidence. Now the governments themselves are the problem and the ECB's help is limited and conditional.

Despite the reasons for disappointment, we firmly believe that the current financial crisis will be addressed. Ironically, the more acute the panic, the more likely a plan will be passed. But from the perspective of investment portfolios, the agreement is unlikely to meaningfully alter the backdrop of deleveraging and weak economic growth in Europe and throughout the developed world. This trend is likely to be far more important to capital market returns than any short- term fix in Europe. No matter how the European rescue plan is implemented, deleveraging and asset sales (sometimes at fire sale prices), low interest rates, slower developed market growth and reliance on demand from emerging markets will continue to be the defining features of the macroeconomic landscape.

Stagnations are not uncommon...

In a recent paper1, Goldman Sachs looked at periods of prolonged sluggish growth ("stagnations") and found that such periods have been quite common through history. Periods of stagnation, commonly associated with Japan's economy in the 1990s, are much more common than is generally thought. Defining stagnation as a period of sub-par growth in GDP per capita that was not interrupted by a recovery to trend growth or by a sharp contraction, Goldman Sachs looked at more than 100 years of history and found 93 episodes, worldwide, that fit this description for more than six years and around 20 that lasted longer than a decade.

Stagnations tend to be characterized not just by sluggish growth but also by high and sticky unemployment and lower inflation. Based on these observations, they conclude that the risk of a Great Stagnation is significantly higher than normal for the major developed economies, at around 40%.

...and offer similar market return profiles.

The stagnations were characterized, on average, by lower equity returns and higher bond returns than normal. Where stagnations are preceded by banking crises, these tendencies are even stronger.

For equities, the returns during a typical stagnation are lower than normal, averaging around 5% per year. That compares to a full sample historical mean of around 8% and a post-World War II average close to 11%. T-bill returns were generally not that different from the normal experience, although they were somewhat higher for the longest-lasting stagnations. Bond returns were generally significantly higher, with the average stagnation experience higher than both the historical and the post-WWII means (at 3.0% and 2.5%, respectively). These bond returns were heavily impacted by the starting level of interest rates, suggesting that bond returns during any stagnation starting from today would be lower than average2.

An important message to investors is that while the average investment environment during stagnations has been more bond-friendly and less equity-friendly than normal, it has been less negative than the Japanese experience on its own would indicate. This suggests that the biggest threat to capital markets is still more likely to come from another recession or financial crisis than from even a prolonged period of sluggish growth.

Moreover, stagnations do not last forever and are typically contained to a small number of economies that are unwinding past financial excesses. In our August Insight we discuss our expectation that emerging economies are likely to experience rapid economic growth, while more developed economies such as Western Europe and the US are facing significant headwinds to growth on account of high public and private debt, large social program liabilities, aging infrastructure and unfavorable demographics. Our 2011 capital market expectations project strong economic growth and equity returns worldwide over the next 20 years but, clearly, the next several years could be marked by below-average growth in the developed world.

So current portfolio risks stem primarily from two issues.

Since stagnations are not generally catastrophic for capital market returns, we think the primary portfolio risks stem from two other unlikely possibilities. A slip into renewed recession or an intensified financial crisis in Europe are the dominant risks to market returns and the largest source of volatility in financial markets currently. We think that the global economy will avoid both of these two outcomes, but until those fears have been put to rest or the risks diminished, it will be hard for markets to move decisively upward.

The second near-term risk is created by the lack of philosophical consensus and political will to address the problems in the global economy. A number of key features of the Japanese experience do not characterize the current situation – for example, the valuation of equity markets in 2007 did not compare to the overvaluation of the Japanese equity markets at the height of the Japanese bubble; and even in housing, the extent of excess in the US was nothing like Japan in 1990. However, there are clear parallels in the low starting point for inflation and interest rates. Deflation and inadequate stimulus intensified the Japanese downturn and, to the extent policymakers repeat those mistakes, could exacerbate the stagnation in the US and Europe.

In the end, we will collectively resolve the crisis.

As investors, we need to derive wisdom from past experience without relying on hope or averages and probabilities. We do have hope and recognize the probabilities, but both of those are based on our research and actual experience. The fact is that the world has faced incredible financial stress and social upheaval in the past, but the human drive and capacity for adaptation and innovation is resilient. The global economy will return to health and the markets will begin providing attractive returns prior to that.

Our key challenge as investment managers is to find a way to remain invested, achieving the returns in the short-run if possible, while mitigating the extreme downside risk. That continues to be the primary focus of our investment team.

Jason Thomas, Ph.D., CFA
Chief Investment Officer

Next Article



1 Goldman Sachs, "From the 'Great Recession' to the 'Great Stagnation'?", Global Economics Weekly, September 28, 2011.
2 Past performance is not indicative of future results.


Circular 230 Disclosure:
To assure compliance with Treasury Department rules governing tax practice, the Treasury Department now requires that all tax advisors attach the following statement to any and all written communication, except to the extent exhaustive steps are taken to satisfy the new guidelines of the regulation. We hereby inform you that any advice contained herein (including in any attachment) (1) was not written or intended to be used, and cannot be used, by you or any taxpayer for the purpose of avoiding any penalties that may be imposed on you or any taxpayer and (2) may not be used or referred

Past performance is not indicative of future results. All investments may lose value. Indexes are unmanaged and may not be directly invested in.