The 3 Biggest Risks to Investors and the Economy
May 31st 2012 5:21PM
Updated Jun 1st 2012 12:44PM
I found myself explaining my thoughts on the markets and the global economy to two different friends on the same day this week. "The markets have done surprisingly well," I said, "at least until May. But there are three huge risks to the global economy, and that means three huge risks to the market." I tried to make these complex topics easy for my friends to understand, and I'd like to share my reasoning with you as well. I'll even offer a few good opportunities to resist any potential downturns, with the best sort of recession-proof dividend stocks on the market.
The slow death of the eurozone
By now it's no secret that Greece is circling the drain. It's been one of the most reliable headlines in financial news for the past few months: "Markets are [up / down] because [something] Greece." It's more often been down -- the Dow (INDEX: ^DJI) has lost 6% since the start of the month, when Greece held its latest elections.
Greece has been in the middle of a deep recession for some time. Gross domestic product, or GDP, has shrunk by over 12% from its 2009 peak. The American economy would have to shrink by $1.9 trillion from where it's at to match the Greek decline. Only one of Greece's last 15 quarters since the end of 2008 saw GDP growth, and even then it was minuscule. Unemployment remains horrendously high, the country's banks are losing depositors' trust, its politics are a running joke, and borrowing costs are higher than the interest rates on most credit cards. The National Bank of Greece (NYS: NBG) has lost almost 80% of its value in the past year, and about 98% over the past five years.
Austerity has failed to produce any positive results, but there's little indication that eurozone leaders are willing to reconsider their strategy. With one tally putting the global costs of a Greek exit at $1.2 trillion, persistent worries are understandable. But we may be overestimating Europe's resilience.
The euro area is second only to the United States in terms of GDP, led by Germany, France, Britain, Italy, and Spain. Italy and Spain are widely seen as the next dominoes in line, and both recently fell into recessions. Britain's anemic post-recession growth stalled out earlier this year, and France is very close to slipping underwater as well. With four of the big five in dire straits, it shouldn't be surprising that eurozone growth as a whole has flattened.
A quarter of Spain's working citizens are out of work thanks to a deflated housing bubble and stifling government regulations. It risks bank runs as major banks continue to get hammered by bad debt, which would put massive pressure on the European Central Bank to offer a bailout or on Spain to leave the euro. Late last year, Italy's borrowing costs went beyond the 7% danger zone that's been followed by bailouts in three other eurozone countries. Its government debt is larger, as a percentage of its GDP, than any other large eurozone country, and larger than that of any bailed-out nation except Greece.
Many of these problems are just as endemic to their home countries as they are the result of broader European weakness. Throwing money at one problem might very well make another one worse, especially if there's little hope that the money will be repaid. After all, that money comes from the central banks of the eurozone's member countries. Taken all together, Europe's decline offers a source of fuel for another slow-burning problem...
China's hard landing
Countries in recession tend to import less. Something about a lack of money flowing around tends to make people buy fewer things. China exports more to the combined eurozone than it does to the United States, but that's not its only problem. A post-crisis credit boom could lead to bad investments that turn rotten, like the "empty cities" that have become a popular talking point for China bears. Many Chinese companies seem to be cooking their books or just flat-out lying -- can the government's numbers be any more trustworthy?
Whether true or not, the numbers have been declining since 2010, from a blistering 12% annual GDP growth rate to just over 8% in its most recent quarter. As a Chinese "hard landing" is often defined as sub-7% GDP growth, this is a source of concern. A number of secondary statistics -- including rail cargo volumes, bank loans, industrial production, and electricity consumption -- have all taken a turn for the worse in recent months.
China's been attempting to create a more robust internal economy to better withstand external shocks, but it's far from immune. A solar panel trade war with the United States isn't likely to help either country, and runs the risk of spilling over onto other industries as well. Punitive tariffs have had major effects on the global economy before, and many just happen to be enacted when they're most harmful. A weak economy can handle a trade war less ably than a strong one, as you might well expect. And America's economy has a significant weak spot of its own...
The fiscal cliff
Remember last year's debt ceiling showdown? It was high drama for political junkies, but a headache for everyone else. Investors felt the pain, too, as the worst drama coincided with a 16% drop in the Dow over the span of about three weeks. The ceiling was raised in the end, but not before the bill doing so wound up stuffed with some potentially unpleasant mandates.
Nearly $1 trillion is set to be sliced off the federal budget over the next nine years as a result of the debt ceiling deal. Defense and discretionary programs will be hardest hit, but the size of the cuts weren't enough for deficit hawks. That could be a problem going forward, since it looks like there may very well be another fight over the debt ceiling this year. If you thought the last one was a doozy, wait until you see what Republicans and Democrats will do in a high-stakes election year.
That's just the initial drop over the cliff, which hides the sharp, pointy rocks of higher taxes below. The Bush tax cuts are set to expire at the end of the year, as is a temporary payroll tax cut enacted two years ago. Higher taxes will help reduce the deficit, but they also siphon money out of a still-weak economy. The harsher the political fight to come, the more likely it is that we fall off. I wouldn't count on olive branch exchanges in the Capitol just yet.
What can you do?
There are always risks, and it's usually the ones you can't see that are the most dangerous. It's impossible to tell just how much any of this is "priced in." At the same time, there are two things you can do: be on the lookout for buying opportunities, and move some money into steady dividend-paying stocks backed by business models that can survive any recession.
Philip Morris (NYS: PM) , despite its European exposure, has one great trump card: Its customers are addicted to its products. Diageo (NYS: DEO) is in a similarly enviable position as a purveyor of alcohol in troubled times. People may not go out to bars, but few are likely to give up alcohol entirely. Both companies should hold up well in any downturn, as should the dividend-paying stalwarts in our most popular free report. Find out more about the nine rock-solid dividend stocks that can secure your future in good times and bad. Claim your free copy now.
At the time this article was published Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights. Motley Fool newsletter services have recommended buying shares of Diageo. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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