Investing and the Euro Crisis
J.P. Morgan Funds
By David Kelly
July 9, 2012
In the summer of 2012, the Euro Zone crisis continues to dominate financial markets as it has done over each of the past two summers. While the solution to the problem remains relatively straightforward, it requires a level of economic understanding, political courage and communication among policymakers that has been absent thus far. Without this, the crisis is likely to lurch forward with only a very slow and painful resolution.
Many investors would, no doubt, like to sidestep market volatility by concentrating their assets in cash and high-quality fixed income until Europe has fixed its problems. However, this is really not an optimal strategy given the extremely low yields available on both. Instead, it is wiser to try to understand the nature of the issue and to adopt strategies which offer a degree of protection from Europe’s problems while providing the potential for long-term growth.
While the European debt crisis has manifested itself in different ways in different countries, it has the same essential problem at its core. Europe is a currency union but not a fiscal union. This means that if an economy gets into severe difficulty there is no automatic transfer of resources from the rest of the Europe, (as would actually be the case in the United States). Thus, a troubled economy also has no ability to devalue its currency and so it languishes in recession. This recession leads to budget deficits and growing government debt.
For Europe, it is simply too disruptive to break up the currency union. This being the case however, other European countries need to transfer resources (in the form of grants, not loans) to the weaker periphery countries to help them grow before fixing their budget problems. However, European leaders have consistently put the cart before the horse, demanding fiscal austerity to reduce budget deficits before reigniting economic growth. While, to its credit, the European Central Bank has acted to protect the European banking system in the midst of this crisis, until Europe adopts more far-sighted fiscal policies, the crisis will likely fester.
For investors, this is no reason to abandon financial markets altogether. One important aspect
of the problem is that the United States is much less vulnerable to the European crisis than
Europe itself. To see this, consider the three main transmission mechanisms by which the Euro
crisis could hurt the United States, namely, by causing financial stress, by undermining
consumer confidence and by reducing U.S. exports.
On the first issue, the European Central Bank has proven quite adept at limiting the impact of the crisis on European banks. However, beyond this, U.S. banks have by now, only modest exposure to the sovereign debt of peripheral European nations. Moreover, the last three years have seen a major improvement in the balance sheets of U.S. banks – so much so that by the end of 2011, U.S. commercial banks had a higher ratio of tangible equity to assets than at any time since the 1940s. This should be more than enough capital to absorb losses on European debt in all but the direst circumstances.
On the second issue, the trade sector of the U.S. economy is actually smaller relative to the overall size of our
economy than is the case for the vast majority of countries. Just 2.1% of our GDP was derived from exports to
the Euro Zone in 2011. Because of this, even if our exports to the Euro Zone were to fall by 20% in a very
deep European recession, the direct impact on the U.S. economy would be to reduce GDP by less than 0.5%.
On the third issue, this may be the European Crisis that cried “Wolf”. In each of the last two years, U.S.
investors have been warned that the European crisis could send the United States back into recession. In
each case, a combination of pent-up demand and improving consumer balance sheets resulted in continued
U.S. economic growth despite a decline in confidence. This summer, it is possible that Americans will
correctly conclude that the U.S. has what it takes to weather a European storm.
While a continuation of the European crisis could well lead to continued volatility in financial markets, it does also suggest an advantage in being overweight U.S. stocks and bonds in a portfolio.
Finally, worries about Europe should be judged relative to what markets have already “priced in”. A decade
of slumps and shocks has fostered a powerful prejudice in favor of bonds and against stocks and this
prejudice prejudice, through the medium of investor cash flows, has led to an extreme in relative valuations.
In early June, we estimate that the P/E ratio on the overall U.S. stock market was lower than it has been in
over 60% of the days over the last 50 years. At the same time, the yield on 10-year Treasury bonds fell to its
lowest level over the same 50 years. By these measures, in early June, stocks were cheaper relative to
Treasuries than in over 99% of the days since 1952.
For investors the question is not whether the financial environment is gloomy and uncertain – it is. The
question is whether this gloom and doubt justifies such extraordinary valuations. We believe not, so for longterm
investors, we think it still makes sense to be somewhat overweight stocks and underweight fixed
income within the context of an appropriately balanced portfolio.
Any performance quoted is past performance and is not a guarantee of future results.
Diversification does not guarantee investment returns and does not eliminate risk of loss.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and
strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not
intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even
estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be
relied upon as advice or interpreted as a recommendation.
The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a
representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the
large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor
cannot invest directly in an index. Indexes are unmanaged.
International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in
accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and
economically stable as the United States and other nations. Investments in emerging markets can be more volatile.
J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses
include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P.
Morgan Alternative Asset Management, Inc.
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© JPMorgan Chase & Co., June 2012
(c) J.P. Morgan Funds
