A quick read-through of the daily newspaper illustrates that the world is a volatile place where seemingly isolated events can dramatically affect investors’ fortunes halfway around the world. This summer, the big news has been Greece and China.
Greece is in financial crisis. It can’t pay its bills, and it can’t sustain its vast social welfare state. Things have reached the boiling point as Greece and its European creditors have butted heads during negotiations designed to diffuse the crisis and get Greece pointed in the right direction. This summer has also witnessed the stunning drop in the Chinese stock market. After a dramatic 60 percent run-up this spring, China’s stock market fell 30 percent during June and July.
Over the past year, experts have struggled to predict what’s next for Greece and the Chinese stock market, and no one is exactly sure how the events in these two countries are going to play out. This caveat aside, it is worth taking a step back and asking what these events mean for our local economy and local investors.
First off, I think it is fair to say that the direct impact of these events on our local economy is likely to be pretty small. Greece represents a small percentage of the world economy, and European financial institutions and central banks hold the large majority of the outstanding Greek debt. Similarly, Chinese investors still overwhelmingly own Chinese stocks. Moreover, on a macro level, the major employers and businesses in our local economy have little direct exposure to Greece and China.
That said, with these types of events, the indirect effects often loom large. Indeed, the world’s economic and political history is rife with examples of when a seemingly isolated small event created a series of cascading effects that ultimately had devastating impact worlds away. With respect to Greece, there is a risk that the events in Greece will spill over to other parts of Europe that are struggling with high debt levels and unemployment (think Spain and Italy, for example). While still relevant, most agree that this concern is smaller than it was immediately following the 2007-2008 financial crisis because the banking system has somewhat recovered and policymakers have done a good job of trying to isolate the crisis to Greece. A second concern is that overly strong austerity measures may push the Greek economy into a tailspin, which in turn may force an exit from the European Union. While Greek citizens will largely absorb the direct impact of these actions, Greece remains a strategically important country and it is unclear what will be the geopolitical impact of a destabilized Greece.
Turning to China: There are always concerns that a crash in one market will spillover and have “contagion” effects in other markets. Arguably, the larger concern is that the decline signals weaker growth prospects for the Chinese economy. If so, this may translate into weaker earnings for companies that depend heavily on China. At the same time, concerns about China may lead global investors to put their money elsewhere, which may stimulate other markets. Astute analysts try hard to gauge these ripple effects when determining which investments to buy and which to avoid. But, as you might imagine, predicting the outcome of these sorts of events is quite imperfect.
On a broad scale, global investments tend to be more volatile than U.S. investments — they also often have higher fees and are less liquid. Given these patterns and the recent events in China and Greece, it may be tempting to simply avoid global investments. But, it is important to remember that global investments often provide tremendous growth opportunities. Over time, efficient global diversification also helps reduce risk.
Keep in mind, however, that you can achieve some global diversification even if you hold exclusively U.S. investments. Many U.S. companies invest overseas and/or rely heavily on global consumers. It is also important to recognize that as global economies become more intertwined, the correlation between the returns of U.S. investments and international investments has steadily increased over time. As a result, the marginal benefits of global diversification have declined as the distinctions between these cross country investments have diminished.
Putting this altogether, a recent Vanguard report summarized the pros and cons of global investing. The conclusion: The average investor should consider allocating 20 to 40 percent of an equity portfolio into international stocks. While this sounds pretty reasonable, you may want to do some homework and/or work with your investment adviser to ensure that you are efficiently diversifying and doing your best to manage fees and taxes.
Joel F. Houston is the John B. Hall Professor of Finance at the University of Florida. Joel’s research is primarily in the areas of corporate finance and financial institutions, and his work has been published in a number of top finance and accounting journals. Joel enjoys playing golf, working out, and spending time with his wife (Sherry), two children (Chris and Meredith) and daughter-in-law (Renae).