High Debt, Low Growth

Summary Points

• Excessive debt is limiting the ability of Greece, Italy, Spain, Portugal, and other countries within the euro zone to stimulate their economies.
• There is concern that crises in Europe could potentially impact the global economy and contribute to a double-dip recession in the United States.
• Investors may want to consider an allocation to blue chip stocks, careful evaluation of U.S. Treasury holdings, the trade-offs associated with excessive cash, and the benefits of tax-advantaged accounts.

Given signs of uncertainty in Europe, predictions about what will happen next are dominating the airwaves and cyberspace. Currently, no one really knows whether a European government will default, whether European officials will agree on a rescue plan, or the outcomes of other concerns that are being debated. But it is important to understand the main factors that are brewing in Europe and to take actions that can help you manage risk.

Growth Versus Debt

The situation in Europe has its roots in excessive government borrowing, slowing economic growth, and a lack of political consensus within the euro zone on a plan to assist financially distressed members. Specifically:

• In 2009, Greek officials announced that the government had spent heavily on public benefits and the country did not have the means to pay its debts. During the past two years, Greece has received a series of bailouts from the International Monetary Fund and the European Union, narrowly avoiding default earlier this year. Greece recently enacted additional austerity measures in advance of an October deadline to obtain $11 billion in aid to remain afloat financially.¹
• Standard & Poor's lowered its long-term and short-term sovereign credit ratings on Italy from A+ to A, indicating the outlook for the country is negative.² An Italian austerity plan passed over the summer may not achieve the desired savings, according to Standard & Poor's, because Italy has a high tax burden and the country is facing weakening economic growth. The downgrade follows downgrades to Greece, Ireland, and Portugal earlier this year.
• In April 2011, the International Monetary Fund and the European Union provided a 78-billion euro ($106 billion) aid package to Portugal.³
• Spanish political leaders are discussing revival of a wealth tax in an attempt to convince potential lenders that the country will control deficits and reform its tax system. Unemployment in Spain was 20.1% in 2010, and Standard & Poor's anticipates economic growth of only 1.0% in 2012.⁴
• The French government recently reduced its forecast for 2011 economic growth from 2.25% to 1.75%. France also is implementing austerity measures in an attempt to retain its AAA credit rating. Moody's downgraded two large French banks, Societe General and Credit Agricole, because of their exposure to Greek debt.⁵
• Recent developments suggest that growth within the euro zone is slowing and, in certain instances, showing signs of contraction. The European Central Bank has lowered its economic forecast for the region, and a preliminary survey of purchasing managers registered the first decline since the euro zone began recovering from recession during the third quarter of 2009.⁶
• The United States and other countries are pressuring the European Central Bank to take quick action to increase the size of a rescue fund to stave off future defaults. Public opposition with Germany and northern euro zone members has raised questions about whether an agreement can be crafted soon enough to avert a Greek default.⁷
• U.S. officials and investors are wondering whether continued economic turmoil in Europe will impact global growth, contribute to further stock market declines, and prompt a dreaded double-dip recession on American shores.

What Investors Can Do

Creating a financial plan to deal with the situation in Europe is challenging because new developments surface every day. But that said, there are steps that may help you manage your financial risk:

• Focus on blue chips. During challenging economic times, large organizations frequently are better equipped than small companies to ride out an economic trough. Although there are no guarantees, large-cap companies also are more likely to pay dividends, which provide a return even when stock prices are in a slump. Look for companies with a history of ongoing or increasing dividends.
• Re-evaluate your bond allocation. Concerns about volatility have prompted many investors to flee the stock market in favor of U.S. Treasury securities. This money flow has bid up prices and driven yields below 2%. Given these low yields, it is difficult to earn a rate of return that exceeds inflation. Consider balancing your allocation to U.S. Treasury securities with other types of bonds with the goal of balancing risk and return.
• Review real estate investment trusts (REITs). Although the real estate market is in a slump in many geographic areas, REITs pay dividends, which are another source of potential return.
• Capitalize on tax-advantaged accounts. Individual retirement accounts and 529 college savings plans present tax benefits. You may want to maximize your use of these accounts when pursuing your long-term financial goals.
• Understand the trade-offs of an excessive allocation to cash. During difficult economic times, many investors believe cash is king. A short-term allocation to cash may be appropriate when searching for investment ideas, but a longer-term allocation may put you at risk of returns that are below the rate of inflation.
• Manage your personal debt carefully. The U.S. real estate crisis and developments regarding sovereign debt in Europe have pointed out the perils of owing more than you can pay. If you have a mortgage and you are able to refinance, consider whether doing so could limit your debt payments. A large mortgage, outsized college loans, excessive use of margin, credit cards, and other forms of debt could work against you if your circumstances change suddenly.

The world economy is navigating a period of uncertainty, and future investment trends may not become apparent for some time. In the meantime, finding appropriate strategies for balancing risk and return may help you stick with a plan when short-term events are challenging.

Investments in REITs are subject to the risks related to direct investment in real estate, such as real estate risk, regulatory risks, concentration risk, and diversification risk.