The direct effect of a bank collapse in Spain and Italy would be much more difficult to digest, however. For the US, bank failures in Europe could lead to a credit crunch, putting stress on large global banks and weakening global economic growth.
There is some evidence that the market is pricing in a small degree of contagion risk. The chart, which depicts US and European swap spreads, shows that US and eurozone spreads spiked during the Lehman collapse back in 2008, reflecting contagion concerns. This means that the risk premiums of debt assets compared to government bonds increased, showing the fear of systemic risk.
US swap spreads decoupled from European spreads during the course of 2009, as market participants started to see the risk to the US as much smaller than that of the eurozone. The two lines continued diverging more strongly in the middle of last year and the gap has remained about the same since. The graph suggests that the risks for the US are moderate, while they are elevated for the eurozone.
Source: Bloomberg
* Swap spreads are the difference between the swap rate on a contract and the yield on a government bond of the same maturity. They are used to represent the risk associated with the investment, since changes in interest rates will ultimately affect returns.
Investment implications for bonds
The European crisis has already led to a divergence in bond yields between countries that are believed to be good credit risks and those that are not. The yield spreads between German bunds and the bonds of the weaker countries have risen in recent weeks as the threat of a Greek default and exit has grown.
In the near term, we expect German bunds to outperform the sovereign bonds of financially weaker European countries. However, yields on German bunds are already extremely low in nominal terms and mostly negative in real terms (nominal yield minus inflation).
We also believe that US Treasuries will continue attracting investors due to the likely continuation of market turmoil and uncertainty. Many investors hold bonds of relative safe-haven countries like the US as portfolio hedges against a possible drop in equities should the European crisis worsen.
For investors, we typically suggest maintaining exposure to international bonds to help provide diversification in portfolios. However, under the current circumstances, risk-averse investors may want to limit their exposure to European sovereign bonds in general due to the uncertain outlook. Within the eurozone, we think German bunds should continue to outperform.
Implications for currencies
Greece leaves
Should Greece and/or other smaller countries leave the euro, their new currencies would likely fall steeply against the euro and other currencies. The Greek drachma would probably depreciate the most, together with the Portuguese escudo, according to their economic and structural imbalances. The euro, however, could experience some appreciation if worries about the financially weak countries no longer burden the currency.
Greece stays
Should countries such as Greece, Portugal and Ireland choose to stay in the euro area, the euro's performance would likely be hampered by crisis flare-ups in the short- to mid-term. Longer-term, the euro’s prospects would depend on these countries' ability to stick to reform and austerity programs, create growth and increase productivity, and bring debt and budget deficits under control. In the medium-term, the US dollar and the Japanese yen would likely benefit, whereas riskier currencies such as many emerging-market and commodity currencies could decline due to lower growth and investors seeking a relative safe haven.
The US Federal Reserve and the Bank of Japan could act to counter the rise in their domestic currencies through more quantitative easing and/or intervention in the currency markets. The Bank of Japan has recently intervened in the markets in an attempt to slow the rise in the yen. The Swiss franc would also likely experience safe-haven inflows, which would test the Swiss National Bank’s ability to defend the threshold of 1.20 to the euro.
Greece leaves, triggering contagion
Should the Greek exit lead to contagion and force bigger countries such as Italy, Spain and France out of the union, the euro's survival probably would be threatened and its value would likely drop. The US dollar and the yen could benefit significantly from such a scenario, while riskier currencies would likely fall more quickly than in the "Greece stays" scenario. The Swiss National Bank could be forced to give up its threshold and, like the yen and the dollar, the Swiss franc would likely appreciate against other currencies.
The bottom line
It appears likely that market turmoil in the eurozone will continue for the near term, at least until the outcome of the Greek elections. Given the changing political landscape in Europe and the slow pace of European officials in dealing with the crisis, we would limit exposure to the euro and its assets for the time being.
Investors who feel they have too much exposure to the euro can either reduce European assets denominated in euros and/or hedge some of the currency exposure away by using currency ETFs, for example. (If you go this route, we recommend being very cautious with inverse and negatively correlated ETFs because their performance can deviate from the underlying exchange rate over time.)
Emerging markets that are most exposed to the eurozone debt crisis are the former Eastern European countries like Poland, Hungary, the Czech Republic and Romania. As the eurozone debt crisis continues, growth may falter and risk aversion may rise. Those economies and their assets are likely to suffer and experience capital outflows, probably resulting in further a weakening of their currencies. Slowing growth combined with mostly weak fiscal positions will probably increase their public debt ratios towards critical levels. We would therefore be careful with exposure to these currencies and their assets as long as the crisis persists.
Important Disclosures
For ETFs, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Past performance is no guarantee of future results.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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