You can’t watch the economic problems in Europe unfold without wondering what the impact will be on the U.S. — and your own finances. The possible outcomes are so varied that specific predictions are worthless, but it is possible to get a general sense of the likely results. Most of the effects will be negative, but there will be a few opportunities as well.
The problems of Europe and the euro currency can best be gauged by considering four ways the situation may play out, in order of increasing severity:
1. Managed default in Greece. It’s highly unlikely that Greece will be able to pay all its debts, so they will have to be written down. Under the most recent plan, banks and other private holders of Greek bonds would have to accept half of what is owed to them. But it’s doubtful that such a write-down would be sufficient to make Greece economically viable, especially since bonds held by public institutions like the European Central Bank would not be written down. Meanwhile, the Greek people are resisting further austerity. So a managed partial default would be hard to engineer, whatever Greece’s new unity government does.
(PHOTOS: Protesters Bring Athens to a Halt)
2. Chaotic default in Greece. If the situation in Greece blows up and turns into a chaotic mess, the damage to the banking system would be much greater. This possibility, unfortunately, is not out of the question.
3. Slow deterioration in much of Europe. The expulsion of Greece from the euro zone would produce a sharp, short-term shock to the global banking system, but the greater worry is ongoing stagnation throughout much of Europe. Given that Italy’s borrowing costs have already reached dangerous levels and that France is not secure either, chances are high that problems will continue for several years.
4. Breakup of the euro zone. The climactic outcome, of course, would be a breakup of the euro zone, or at least a splitting into two halves. From a long-term point of view, this would make a lot of sense, economically. But it could produce a tidal shock wave.
Whatever happens, there will likely be a difficult period ahead for the U.S. Since current stock prices already reflect some risk, one would imagine that the downside is less than it was in early 2009, when the Dow briefly plummeted below 7000, but greater than earlier this year, when the Dow fell to 10,772, (or 2010, with a drop to 9687). These benchmarks cover a pretty wide range, but they do get to bear-market territory (a decline of 20%), with the possibility of a brief plunge well below that.
Economic problems in Europe would have broader consequences as well. In particular, they would lead to a contraction of credit as banks absorbed losses on government bonds and cut back on lending. If world economies were booming, this might be harmless. But the U.S. has made little progress recovering from recession. In this environment, credit contraction could cause a double dip and would certainly prolong this period of slow growth, high unemployment and weak real estate prices.
In response, the Federal Reserve and European central banks will try to maintain adequate credit, which will likely mean growth in the money supply and continued low interest rates. Such a policy may mitigate the effects of current problems in the banking system but also create the conditions for an eventual revival of serious inflation.
What, then, would be an intelligent financial strategy for an individual in the U.S.? Basically, defense, with an eye out for buying opportunities.
• Expect continued sluggishness. The economy appears to be past the bottom, at least as far as corporate profits are concerned, but a full recovery — including unemployment and real estate prices — could take several years.
• Minimize your debt, maximize your liquidity (i.e., available cash) and try to manage down your monthly expenses as much as you can.
• In your stock portfolio, maintain a cash reserve and wait for opportunities to buy high-quality assets at bargain prices. Shares of companies with little debt, solid long-term business prospects and current yields above 3% will likely look cheap in retrospect several years from now. As I have discussed in previous columns, such stocks can be found in sectors including energy, technology, consumer staples, health care and personal care.
• Keep some money in reserve to buy opportunistically in the event of a blowup in Europe. Exchange-traded funds that invest in Germany and the Netherlands will be solid long-term buys but could be temporarily knocked down to bargain levels. I’m also keeping an eye on ETFs (such as PFF and PGF) that hold the preferred shares of major U.S. banks. They currently yield more than 7.3% and could go to 8% or 9% in a banking-sector panic. But the funds are broadly diversified, and the preferreds they hold will be safe unless the banks come close to failing.
• Consider buying real estate, if you have a long horizon. This is especially true if you are renting and would basically be exchanging your monthly rent for mortgage payments. Home prices may take a long time to recover, but in most places, they’re cheap. You will not only be locking in a low price before the recovery but will also have a valuable inflation hedge.
For a more detailed discussion of the near-term outlook for the economies of Europe and the U.S., it’s worth watching CNN’s recent interview with Pimco CEO Mohamed El-Erian.