Third Quarter 2011 in Review

It has been a volatile quarter in the financial markets. With this in mind, we thought a quick overview and perspective on the continuing fiscal crisis facing Greece and other European nations might be helpful.

For more than a year, headlines in the financial media have been dominated by news of a solvency crisis in the European Monetary Union (EMU), which is composed of the European countries that use the euro currency. Several European countries (specifically Greece but to a lesser extent Portugal, Ireland, Italy and Spain) have serious fiscal problems.

The members of the EMU agreed in 1997 to a Stability and Growth Pact, which stated that in order to be a member, states would need to meet particular criteria. Specifically, a nation’s annual budget deficit could be no higher than 3 percent of gross domestic product (GDP is a measure of a nation’s economic output), and a nation’s debt had to be lower than 60 percent of GDP. Over time, it was discovered Greece’s deficits were much higher than 3 percent of GDP, and other EMU nations had deficits that exceeded 3 percent of GDP, although none had a fiscal situation as dire as Greece’s.

In 2010, European central bankers negotiated a bailout package to help Greece get back on its feet and on the road to fiscal stability. Despite this bailout, Greece’s fiscal situation has continued to deteriorate. Further, economic growth in the region has been slow.

The risk of default in Greece is high, and a Greek default will not come as a surprise to the market.

European leaders have taken actions to prevent default by Greece and other EMU countries. They have also taken steps to mitigate the impact of a possible Greek default. The European Financial Stability Facility was created in 2010 to provide funding for the region’s troubled countries, and many have made hard decisions to get their houses in order such as cutting back on public worker payrolls and pensions. Greece has raised its tax rates in an attempt to generate more revenue.

We suggest two lessons from this crisis. First, broad diversification is a winning strategy. EMU residents who elected to invest exclusively in stocks located in EMU countries are paying for this choice. Over the past 12 months, the MSCI World excluding EMU Index has outperformed the MSCI EMU Index by 15.9 percent (in euros). These types of crises can happen anywhere and are difficult to predict, so investing in a diversified portfolio is the best preparation for future crises.

Second, when investing in stocks, it is important to have a long-term perspective and understand that while stocks have historically earned higher returns, these higher returns are mostly compensation for higher risk. More than likely, the solvency issues in Europe will linger for some time. Despite this, a long-term perspective might be in order. In 1998, Russia devalued its currency, defaulted on domestic debt and declared a moratorium on payments to foreign creditors. At that time, the picture looked bleak both for Russian creditors and investors in Russian stocks. It took a while, but from 2009 through the end of the third quarter 2011, the S&P Russia Index returned 27.1 percent per year. This isn’t to say that EMU countries will achieve the same impressive stock market returns Russia has achieved over the past few years; this is to say that over the long term, crises can turn into distant memories.

We appreciate the trust you have placed in us. Our objective is to help you achieve your financial goals. If you have friends or associates who would benefit from our professional advice, we would be happy to meet with them to see if we can help.