In Europe the euro debt crisis is nothing but bad news.
Riots in Athens. Strikes in Spain. Shrinking pay checks. 20% unemployment. Rising taxes. Cuts to government services. Hard times for as far as the eye can see.
In the U.S? Sure, the crisis has sent a shiver (well, make that a great big shudder) through the stock market but it’s also responsible for falling interest rates, cheaper mortgages, and lower gas prices.
In the medium term it might even lead to sooner-than-expected turnarounds for emerging stock markets from Brazil to China.
Globally the euro debt crisis has sent stocks tumbling from New York to Sao Paulo on worries, well-founded worries, that the crisis will spread from Greece and Spain and Portugal to, first, France, and then to banks as far away as California. The People’s Bank of China isn’t talking but Beijing’s foreign exchange reserves, held increasingly in euros in recent years as China diversified away from the U.S. dollar, have certainly taken a beating from the 15% decline in the euro. Prices for everything from oil to copper have plunged.
But no bad deed goes completely unrewarded.
And the euro crisis is actually good news if you’re thinking of buying a home in the United States, or own a portfolio full of U.S. Treasury bonds.
The crisis could even make U.S. stocks the best performing in the world for a while. (Yes, I think the current market drop is a correction and corrections end.)
Further afield although the crisis has fed into relentless declines in emerging market stocks—iShares MSCI Brazil Index ETF (EWZ) is down about 13% for 2010 and the Shanghai stock market is in a bonafide bear market with a better than 20% decline from its November 2009 high. But for these markets the euro debt crisis promises an accelerated end to the decline and a quicker rebound. (For more on China’s bear market see my post http://jubakpicks.com/2010/05/18/chinas-bear-how-long-are-its-claws/ )
What are the magic ingredients that have turned what is unrelievedly bad news for Europe into good news for U.S. home buyers, U.S. investors, and developing economy stock markets?
Lower interest rates and lower inflation.
In the United States the euro debt crisis has worked like this:
The euro’s pain has been the U.S. dollar’s gain. Investors, traders, and speculators fleeing a sinking euro have bought dollars and dollar-denominated instruments such as Treasury bonds. That’s moved the yield on the 10-year Treasury bond, the one that many mortgage lenders use as their benchmark, down to 3.34% on May 18.
That’s a huge turn around. The yield on the 10-year Treasury had been on an inexorable march upward as financial markets prepared for the Federal Reserve to start increasing interest rates and as bond buyers demanded to be paid more to take on the risk of a falling dollar. From 3.14% on May 15, 2009 the yield climbed to 3.94% on April 9, 2010. Some days it flirted with the psychologically important 4% threshold. And then as the euro crisis hit, the yield on the Treasury plunged. In the bond market where daily changes in yield are normally measured by a few hundredths of a percentage point, the yield on a 10-year Treasury fell by 60 hundreds of a percentage point in a little more than a month. That’s a 15% decline in yield in a month. If we were talking about the Dow Jones Industrial Average, we’d be shaking our heads over a 1600 point drop in the index.
The U.S. Treasury market has seen bond buyers go from worried about interest rate increases as early as the fall of 2010 to a belief that the Federal Reserve won’t move until 2011. Bloomberg’s regular poll of economists showed that as of May 10 the median forecast called for a very modest 0.25 percentage point increase in interest rates to 0.5% by the end of 2010. That’s down from the April 29 median forecast of a 0.75% target rate by yearend.
Why the change? The thinking is that with the euro debt crisis causing growth in the Euro Zone economies to slow to 1% or less in 2010, the Federal Reserve will be extremely reluctant to slow U.S. growth with interest rate increases and risk stalling the U.S. economic recovery.
The reversal in interest rates has rippled out across the U.S. economy.
For example, mortgage rates have fallen almost as fast as Treasury yields. On May 18 the interest rate for 30-year fixed mortgages was 4.70%, down from 4.79% on May 11, according to Zillow Mortgage Marketplace. The last time the interest rate on a 30-year mortgage was this low was in December 2009.
Lower mortgage rates are, of course good for a U.S. housing industry that is still crawling off the bottom. Housing starts boomed in April, government numbers released on May 18 showed, with builders starting construction of 672,000 new homes, well above the consensus projection of 655,000 and the highest level since October 2008. Housing starts remain at an extremely low level and it’s premature to talk about a recovery but I think it is fair to say that the housing industry is showing signs of stabilization. And that’s good news, especially because economists feared that higher mortgage rates would send home sales and starts back down.
The reversal in the upward direction of interest rates and lowered expectations that the Federal Reserve will move on rates any time in 2010 have also turned income investors’ strategies inside out. While earlier in the year income investors were moving away from Treasuries because they thought bond prices were due for a decline as interest rates climbed, now Treasury bonds promise positive total returns for the year. Yields are still absolutely low but a 2% plus real yield (that is the yield of 3.34% minus the 1.1% annual rate of inflation as measured by the core Consumer Price Index) stands up pretty well against the volatility of the stock market right now.
And, of course, the euro debt crisis, with its guarantee of lower economic growth in the Euro Zone and lower demand for global commodities such as oil and copper, promises to put a damper on global inflation. In the United States that will be one more reason for the Federal Reserve to put off raising interest rates anytime in 2010. In the world’s emerging markets lower inflation is likely to mean a more rapid end to moves by governments and central banks that have sent stocks in those countries reeling. (For more on how this is playing out in China see my post http://jubakpicks.com/2010/05/11/chinas-stocks-enter-bear-market-territory-on-inflation-fears/ )
Higher commodity prices aren’t the only reason that inflation has picked up in China, Brazil, India and much of the rest of the developing world, of course. (In many of these countries, and in China in particular, there’s the little matter of a run away money supply.) And it will take months of lower than expected inflation numbers to convince central banks in emerging countries that they can relax sooner rather than later. But there’s a good chance that lower commodity prices will result in central banks that were planning on four interest rate increases stopping instead with three. I think this is especially likely in emerging economies with a strong commodity export sector. In those cases stagnant or falling commodity prices will cut into inflation at home as well as slow the economy as export growth moderates as a result of the euro debt crisis. Brazil is to my way of thinking the prime example of just such an economy. Indonesia would be another in that group. (For more on plans by the Banco Central do Brasil to raise interest rates see my post http://jubakpicks.com/2010/05/14/economic-growth-policies-to-fight-inflation-and-now-budget-cuts-in-an-election-year-from-brazil/ )
Right now the fear that the euro debt crisis will spread beyond the Euro Zone and that slower growth in Europe will derail the global recovery overshadows any more nuanced way of looking at the results of the crisis. When you’re worried that the world is coming to an end, you don’t stop to notice that spring has come early this year.
The euro debt crisis is indeed a major economic and financial crisis that will play out across the world. But the complexity of the connections in the world economy, the way that on pieces pushes on another so that a third goes up while the first rocks down, pretty much guarantees that bad news is almost never uniformly bad news in every market and for every consumer and investor.
Toward the end of what is shaping up as a very rough 2010 I think investors will have gained enough perspective—which is just a fancy way to say that the fear will have receded a bit—to start to bid up stocks in emerging markets as interest rate increases and inflation fighting policies end shorter than expected runs.
The stock market rallies that will result will be based largely on the strength of these emerging economies. But today’s euro crisis will play a part—if only to the degree of speeding up a return to accelerating growth in the developing world.