Investors are fearful of the spread of sovereign debt problems. That fear has become contagious.
Markets around the world have been hit by a wave of selling as nervous investors head for safety. The over-riding concern is the "contagion" spreading from the Greek credit situation. Today, Spain is in the headlines. Fears are mounting that other countries might also catch the "contagion".
The collapse of Greece, Spain and several other countries in the euro-zone might put the very existence of the euro at risk. At the least, such a collapse would plunge Europe back into recession. And, of course, that would bring the fragile recovery in America to an end and the whole world would once more slow down.
Sovereign debt defaults would indeed have serious consequences to the euro and to European economies. While the risk is there, let's look objectively at the chances of a default.
The European Central Bank and the International Monetary Fund have pledged $1 trillion to back-stop European sovereign debt. Nobody has actually written a cheque for that amount, but it demonstrates the same level of commitment that America took to stem the panic that followed the banking collapse in 2008.
While headlines are focused on the weaker links in the European economy, the largest member is recovering nicely. The jobless rate in Germany declined to less than 8% as manufacturing growth accelerated and business confidence jumped to a two-year high.
It's not hard to see how the fear spreads. For example, a popular commentary service distributed the above graph of LIBOR (London Interbank Offer Rate), which is the interest rate at which banks loan to one another. As presented, the chart seems terrifying, showing a sky-rocketing rate and implying a collapse of confidence among banks.
However, there was no scale on the Y-axis of that chart as it was distributed. Adding in that bit of useful information, the chart shows LIBOR increasing from the December to March level of approximately 0.25% up to 0.5%.
Looking at the same data with a longer-term perspective (and including a scale on the Y-axis that starts at zero) shows a somewhat different story.
While LIBOR has increased of late, banks are still loaning to one another at a rate of one half of one percent – hardly an indicator of imminent collapse of the banking system. Note that the rate during most of the past five years was between 2.5% and 5% – five to ten times the current rate.
Given the strength of the commitment to support sovereign debt, it seems most likely that defaults will be averted. However, there will be a huge cost: Government debts are ballooning and the constraints being imposed will dampen economic growth.
As with the European situation, news about the U.S. economy is also focused on the negatives. Positive news is often glossed over. For example, U.S. consumer confidence rose for a fifth straight month, reaching a level well above economists' expectations and a 2-year high. That news failed to attract headlines. One major news service buried news of growing consumer confidence in an article on the economy, and qualified it with the statement that some people thought that confidence might drop next month. American consumers represent two thirds of that country's economy.
There is no question that Europe and America will continue to muddle along. The chances of a default or other catastrophe are minute, but the economies will grow slowly for some time yet.
Now, let's look at the other side of the world: Some people are talking about a potential bubble in the Chinese housing market, which might bring down that economy. While prices have risen sharply, and may correct, there is nowhere near as much debt behind the rising prices as there was in America in 2008. The average house in China is funded with 50% equity. The savings rate in China is still very high and consumer debt low.
The popular press is also talking about a slowdown in China. Again, a little objectivity is in order. The Chinese economy grew nearly 12% in the first quarter. The government has stepped in to contain the pace of growth to around 10%.
Growing tensions between North and South Korea have added to the uncertainties in the region. The North/South conflict is again in the headlines, relating to a serious incident (the sinking of a warship with substantial loss of life). However, it is worth remembering that the conflict has been going on for 60 years and there have been other incidents in recent years where the North has inflicted damage and loss of life on the South.
The fear in Europe, talk of a "slowdown" in China, and the Korean situation have cast a black cloud over stock markets. Fear still permeates the markets. That fear may depress stock prices further. Running for cover to avoid headline-induced fears may provide short-term security, but will not generate meaningful returns.
Those investors willing to look beyond the headlines may note that the latest forecast from the IMF shows the global economy growing at more than 4% this year. Strong growth in the developing world is pulling up the meager pace in the developed world.
It seems clear that investors should avoid investing in the sovereign debt of deeply indebted nations and instead look for opportunities in the developing world.
The simplest play on developing economies is resources. Resource-based economies, notably Australia and Canada, are doing well, as mining companies are working flat out to satisfy the growing demands for metals. Many investors still see a return to recession as being imminent, and therefore metal companies get little respect from investors.
The copper price was closing in on its all-time record high before sovereign debt concerns brought on fears of a slowing economy. The strong rebound in the price over the past year reflects the growth in metal demand in the developing world.
Another important theme for investors to consider is that soaring government debts will inevitably lead to further currency devaluations. At this moment, the US dollar is seen as a safe haven. In due course, the huge and rapidly growing debts of the world's largest debtor will return to the headlines. Over time, gold will continue to benefit from the mounting concerns about the stability of currencies in general.
Most investors recognize the long-term value of metal companies. The question is what will happen between now and the long term.
Stock markets have corrected across the board. There is still further down-side risk, but this looks like a good time to start buying the better quality development-stage companies.
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