We may be in the calm before the storm. That’s how I view the somewhat muted reaction by U.S. and European markets to this weekend’s Greek “No” vote on more European Union (E.U.) austerity and China’s unprecedented stock market declines.

Investors should use this market under-reaction as a gift to sell out of high-risk positions, as it will be too late when a true sell-off arrives. Also, you’ll want cash on hand to take advantage of buying opportunities.

Many analysts say the market’s muted reaction was as a result of money managers expecting an eventual deal between the E.U. and Greece, and that the Chinese government’s efforts to stabilize stock markets would prevail. Not to mention a lack of attention due to the July 4^th holiday also probably played a factor.  

But the implications of these crises are that world governments will likely keep rates low in fear of weakening global growth. The International Monetary Fund warned the U.S. risks stalling the recovery by raising rates in September.

And a global economic downturn or major correction is likely if a Greek exit destabilizes the European Union, and a major slowdown in China occurs simultaneously.

We have said that the Greek drama could be the beginning of the beginning of a debt crisis, where serial defaults or restructurings lead to volatility in global income investments.

We do know that a Greek exit would likely cause a recession in the region. A recent Oxford Economics report says a Greek exit from the Euro zone would mean lower European stock prices, increased bond yields for countries such as Italy and Spain, and lower confidence and in European investments.

Morgan Stanley forecasts a contraction of 0.2% in the Eurozone if Greece leaves. This scenario, if it occurs, could ultimately hurt the U.S. recovery as Europe is one of its largest trade partners. 

We would hope to see a resolution where Greece stays in the European Union. But we also believe it may not be a question of “if” but “when” the EU will have to deal with another existential threat given the debt levels of other members. So we want to see substantive reforms by the E.U. before we recommend direct investments there. 

Since last year we have actively diversified away from investments on the European continent. Half of our positions are U.S.-based companies, and have limited operations in Europe or have well-diversified global operations.

The Great China Crash

The bigger crisis is what is happening in China’s stock markets, as $3 trillion dollars has been wiped off the value of the all listed companies in the last few days. 

China Market Diving

Source: Bloomberg
Comparisons are being made to the U.S. Great Crash of 1929, and there should be great concern in terms of U.S. investment here as global financial markets are increasingly interconnected.

Notwithstanding, Goldman Sachs has argued recently that there is no stock market bubble, and some market players even argue that a 27%rally is still possible. But as conservative income analysts, the steep drop gives us pause.

We have long considered a scenario of global instability as a result of uneven economic growth, high debt levels and low capital investment. So we have designed portfolios that invest in firms that are highly diversified globally, have pricing power, economies of scale and a competitive advantage, and on balance our portfolios held up well.  

Please see our next issue on July 12, where we will be reviewing how fixed income opportunities have changed as a result of the new instability in global markets, and since the 2008 financial crisis.