Not since Hitler’s armies stormed into Paris have affairs in Europe received greater attention—or caused greater concern—than today’s debt crisis. But just how subject is the U.S. economy to contagion from across the Atlantic? And what actions—if any—might a wise investor take to protect against a potential financial blitzkrieg?
The first order of business is to put the dangers in perspective. Yes, the financial trouble is very real, but that trouble is mainly limited to five of the 27 countries in the European Union. These five—Portugal, Italy, Ireland, Greece, and Spain (often referred to as PIIGS)—are facing enormous financial problems, but the major European economies—Germany, France, and the U.K.—are not in such horrible shape. “Many EU nations are not only financially solvent, but are arguably in better financial health than the U.S.,” says F. John Mathis, professor of global economics and finance at the Thunderbird School of Global Management in Glendale, Arizona.
In fact, we do much more trade with Canada, Mexico, and China than we do with countries in the EU. And within the EU, the five most troubled nations (PIIGS) are minor trading partners with the United States. [See chart below.]
While a handful of EU nations face severe financial turmoil, those troubles alone cannot sink the U.S. economy, says Mathis. “The largest danger the debt crisis in Europe poses to the U.S. is psychological,” he asserts. The recent volatility in the U.S. stock market coupled with the collapse of housing have many of us fearful about investing in general. In this context, the potential of certain EU governments drowning in debt is creating more worry, not all of it justified, says Mathis.
How bad will the EU crisis get? Bugra Bakan, CEO of Shield Wealth Management, says many fears about the EU market have already been baked into stock prices. “The stock market tends be a great discounting mechanism that often anticipates the worst,” he says. In short, the recent decline of EU stock prices reflects the well-known possibility that one or more governments could go bust. “Given the current low prices of EU stock, whatever happens next, it is more likely that share prices will shoot up rather than fall further,” says Bakan.
With all the uncertainties ahead, you can assume that European stocks will be volatile. But so will U.S. stocks. And considering the huge size of their economy and the amount that the EU imports from the outside world, the rest of the world’s stock markets may be in for a wild ride, too.
You’ll have to decide if that ride is too wild for your taste, but Bakan favors keeping some EU holdings in a diversified portfolio. “In a moderately aggressive portfolio with 50 to 65 percent in stocks, I recommend that about 10 percent of the portfolio be allocated to EU stocks,” he says. Low-cost, well-managed funds that track the EU stock market are good options for most investors, says Bakan, including the Vanguard MSCI Europe ETF (symbol VGK), or the iShares MSCI EMU Index Fund (symbol EZU).
Paris, after all, was eventually liberated. And Europe, although severely damaged by World War II, came back strong. We may be in a down phase of an economic cycle, but “cycle” is the very word. This is not the end of times.