Ancient superstition holds that bad things come in threes, and investors witnessed dramatic evidence of this phenomenon in the last few weeks. Although largely unrelated, the near-collapse of the Greek economy, the admission by Puerto Rico’s governor that the island’s debts were unpayable, and the free fall in the Chinese stock market sent shock waves through financial markets. Equities most directly affected by these events suffered sharp declines, but have since stabilized. Puerto Rico municipal bonds remain depressed.
As investors contemplate the longer-term impact of each of these seemingly isolated events, which should they be most worried about?
Much has been written about the economic crisis in Greece and the likely fallout from a possible exit from the Eurozone. As of this writing, the compromise deal hammered out a week ago has yet to be approved by European parliaments. It is clear that neither side wants to face the economic and political consequences of a “Grexit.” Therefore, odds are that the deal that forces the bitter pill of more austerity in exchange for debt relief (i.e. restructuring or forgiveness) is likely to pass. However, the Greek drama does not end there. Without substantial future growth in the Greek economy (which is about one-quarter smaller than it was in 2007), Greece will never be able to repay its debt.
Greece is likely to be an occasional and recurring problem for European creditors for years to come, and the likelihood of an eventual exit from the euro cannot be dismissed. For Greek citizens, the consequences are dire, but for U.S. investors, the impact is expected to be small.
While the depth of Puerto Rico’s fiscal problems have been well understood for many years now, the bluntness of Governor Alejandro Padilla’s comments caught the markets by surprise. Puerto Rico has more than $70 billion in debt outstanding, a greater sum per capita than any other state. Because of the triple tax exemption on Puerto Rico debt granted by Congress years ago, high tax bracket investors eagerly snapped up Puerto Rican bonds without regard for underlying credit quality. Additionally, some of the bonds were backed by municipal bond insurance, increasing demand.
Holders of Puerto Rico debt are likely to suffer losses as the Commonwealth attempts to restructure its debt load, but its problems are not likely to impact the broader municipal markets, nor should it have any measurable effect on U.S. economic activity.
Of these three confidence-rattling events, the water-fall 37% decline in China’s Shenzhen A-Share Index in a span of less than a month is probably the most worrying. The loss of Chinese stock market value over this period was more than ten times the total amount of Greek debt outstanding, which helps put in perspective the magnitude of each economy’s global economic footprint. The Chinese government has embarked on unprecedented direct intervention in the stock market (much of which would be illegal in the United States) to reverse the downside momentum. While Chinese stocks seem to have found their footing in the near term, further declines could begin to spill over into the “real” Chinese economy, impacting consumer spending, debt repayment, and consumer confidence. It would not be hard to see that weakness extending to the larger global economy. For now, we do not see that as a probable outcome, but we are paying close attention.
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