Recent stock market activity appears to be headline driven, depending on the latest news from the euro zone.
The S&P 500 Index has been a hostage to the headlines, up one day and down the next, depending largely on events in Europe and questions about what they could mean for the U.S. economy. A recent example was the November 30 rally on the news that the Federal Reserve will lead an effort by six central banks to increase global liquidity and avert a credit crisis.1
While the action was a welcome intervention following tense negotiations among heads of state, it is likely that the agreement will not address the root cause of the problem: a lack of confidence in European sovereign debt.2
Too Much Borrowing
Europe’s challenges stem from a history of significant government borrowing by Italy, Spain, Greece, Ireland, and Portugal, among other countries. When the Greek financial crisis first erupted in 2010, questions about contagion led to borrowing costs that suddenly were unaffordable for Greece and many of its euro zone neighbors. A one-trillion-euro bailout fund was created in October 2011, but it quickly became apparent that the fund was not adequate. Standard & Poor’s has put euro zone countries on credit watch, indicating their bond ratings may be lowered if the situation is not addressed.3
Looking Ahead: Slow Growth and Contraction
The Organization for Economic Cooperation and Development (OECD) anticipates that economic growth will be muted — or it will potentially contract; with the United States in better shape than many countries within the euro zone.
What Investors Can Do
Although there are no guarantees, the following strategies may help to maintain a portfolio’s value as events unfold in the euro zone:
- Diversify bond holdings. Many sovereign nations, including the United States, maintain strong credit ratings and the capability to repay bondholders. That said, diversifying fixed-income holdings to include corporate and municipal offerings and being selective in your choices could make your portfolio less dependent on developments in one area of the bond market.4
- Investigate revenue streams outside of Europe. Organizations that do a significant amount of business in North America or emerging markets may help to insulate your portfolio from the worst of Europe’s problems.5
- Look for companies that generate cash. Organizations with consistent profits may be in a strong position to withstand a credit crunch if lending standards tighten.
Diversifying your bond holdings, looking for revenue streams outside of Europe, and identifying companies that generate cash may be beneficial strategies for mitigating the impact of euro zone developments on your portfolio.
1Source: money.cnn.com, “Dow Closes with Largest Gain Since March 2009,” November 30, 2011.
2Source: Standard & Poor’s Equity Research U.S. Sector Outlook, “Debt Drag,” November 22, 2011.
3Source: Standard & Poor’s, “Standard & Poor’s Puts Ratings on Eurozone Sovereigns on CreditWatch with Negative Implications,” December 5, 2011.
4Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. Interest income on municipal bonds may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.
5Emerging markets are generally more volatile than the markets of more-developed foreign nations, and therefore you should consider this market risk carefully before investing. Investors in international securities may be subject to higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities.
© 2012 McGraw-Hill Financial Communications. All rights reserved.
February 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.