July 1, 2015

Beyond the Noise: A Look at Greece, Puerto Rico, & China

In Market Commentary

Three events in financial markets have received significant media attention in the last week: a potential Greece exit from the Eurozone, a potential default by Puerto Rico on its bond holdings, and the significant decline (after a rapid advance) in China’s equity markets.  The Coldstream Investment Strategy Group thought it important to cut through the “media noise” and let you know our views on these events.


Near Term Uncertainty in Greece

As you may have heard, Greece missed a $1.7 loan billion payment to the International Monetary Fund on Tuesday.  While this event and the closure of the Greek banking system are dominating news coverage this week, a $3.9 billion bond payment due to the European Central Bank on July 20 is much more important to world markets, since failure to pay would put Greece into a formal state of default.  The situation remains extremely fluid, with developments coming nearly hourly.  It is unlikely that current negotiations will lead to an agreement prior to a scheduled July 5 referendum, which will indicate whether the public will accept further austerity in order to stay in the Eurozone.  Since the current government was elected on an anti-austerity platform, it may collapse if the referendum passes or if a deal on further spending cuts and tax increases is struck in the meantime.

Potential Outcomes

After living well beyond its means in the 2000s, Greece now faces an unpleasant choice: agree to additional austerity and receive a new bailout package or default on its debt and exit the Eurozone.  It is difficult to see how Greece could default and remain on the Euro, and Greece’s creditors are not going to simply absolve it of its debt.  The odds of these outcomes are continually changing and difficult to assess, but in either case we see limited impact to investment markets.  Greece has been a “slow-motion train wreck”, which has given regulators and financial institutions five years to prepare for a default or restructuring.  Unlike in 2011, the vast majority of Greek debt is now held by the ECB, the IMF, hedge funds, and other agents that do not pose a systemic risk to the European or global banking systems.  The ECB has also taken extraordinary measures to provide liquidity, including a recently implemented quantitative easing program.  We also note that Greece makes up only 1.5% of the European Union’s GDP and is a smaller economy than the state of Missouri.

Our Long Term View

While Greece gives the global markets and the media something to fret over, this situation pales in comparison to the 1997 Asian currency crisis, the 1998 Russian debt default, or the US housing and financial meltdown of 2008.  We are advising clients to look past the noise and focus on elements we can control, such as building diversified portfolios, creating appropriate goals for return and risk, and planning for cash flow needs and major life events.  These factors, far more than any one country or market, govern the long-term success of our portfolios.


Possibility of Default

On Sunday, the Governor of Puerto Rico declared the territory’s debt of more than $70 billion to be unpayable.  Standard & Poors downgraded the territory debt to CCC- from CCC+, which implies Puerto Rican investments are highly speculative and likely to default.  The origins of Puerto Rico’s unmanageable debt stem from a decade of climbing public sector deficits amidst declining economic growth, a situation that was magnified by the 2008 recession.  Public sector debt for the island is over 100% of Puerto Rico’s GDP.  Should Puerto Rico default, it would be the 3rd largest sovereign default in modern history behind Greece and Argentina.

As a United States territory, Puerto Rico does not have the ability to claim Chapter 9 bankruptcy, which is reserved for municipalities in assisting a restructuring of debts.  For instance, Detroit was able to use Chapter 9 in their much publicized 2013 restructuring.  Thus, the exact form that any debt restructuring would take is yet to be determined.

Potential Impact

We do not currently believe the Puerto Rican crisis will lead to meaningful contagion to the broader municipal bond market. However, there is a possibility that the price of high yield municipal bonds may experience temporary fluctuations, especially the bonds of a few financially troubled states and municipalities (e.g. Chicago).  Our view stems from the fact that most municipalities have improved their balance sheets since 2008; unfortunately, Puerto Rico has not.  In addition, Puerto Rican bonds have declined over 8% year to date, while the broader S&P High Yield Municipal index is up 0.58% for the same period.  We continue to monitor the situation closely and will let you know if our views change.


Equity Market Bubble

From 2003 until recently, real estate in China rapidly appreciated. For example, prices for homes in Shanghai increased by 150% in 10 years, and housing rose to 20% of China’s GDP.  Last year, the Chinese government imposed a series of policies that made real estate investing difficult, and subsequently eased restrictions on stock market investing.  As a result, real estate prices declined, and an equity bubble replaced the property bubble.  By the middle of June, the index of stocks on the Shanghai exchange increased over 160% in one year, making the market cap of China’s equities second only to the market cap of US equities.  As of Monday, June 29, China’s equity market had dropped over 20% in less than one week as the government imposed stricter margin requirements on investors.

Potential Impact

Some fear that a collapse in China’s stock market could impact China’s consumer spending, resulting in a significant slowdown to its economy and negatively impacting global growth.  Our view is that movements in China’s stock market are significantly influenced by government policy. We witnessed this on Tuesday, June 30th when the government lowered a key interest rate and the equity market rebounded from its lows.  If Chinese stocks reverse course again and a dramatic decline re-occurs, we anticipate that the government will either lower key interest rates again, ease margin requirements or take some other action in order to spur its equity market.  While we do have concerns about the slowing pace of China’s economic growth, we do not see China’s domestic stock market as a source of global financial instability currently.

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