Global financial markets, many of which are at historically if not necessarily record-high levels, suddenly look vulnerable.
With Greece poised to default on its debt, the Shanghai Stock Exchange Composite index plunging 14 percent in just five days (though rebounding slightly on Tuesday) and Puerto Rico needing to restructure $72 billion in public debt, there seems to be a real possibility of contagion that could send markets reeling worldwide.
Mohamed El-Erian, the chief economic adviser at Allianz, has warned that Greeces debt crisis alone puts financial markets at risk. He believes theres an 85 percent chance that the beleaguered nation will leave the euro zone.
In addition to Chinas stock drop, the STOXX Europe 600 index fell 2.7 percent on Monday, and the Standard & Poors 500 index lost 2.1 percent. Nonetheless, there are plenty of arguments to be made against global financial market contagion.
Should Greece not reach an agreement with its creditors, the rest of Europe would be largely insulated quarantined from Greeces woes. Greece accounts for less than 2 percent of euro zone gross domestic product, which helps explain the euros strength on Monday, rising to $1.1239 from $1.1167 on Friday. Beyond that, other euro zone nations banking systems are far healthier than that of Greece, and the European Central Bank has made clear its commitment to support the euro.
In Puerto Rico the government may well come to an agreement with its creditors. Many hedge funds hold Puerto Rican paper and thus have an incentive to help the territory avoid default, which would wreak havoc on the U.S. municipal market, already weighed down by the financial weakness of some U.S. cities and even states. Puerto Rican government bonds are widely held by U.S. investors.
Still, Puerto Ricos predicament hasnt yet hurt U.S. municipal bond funds, which include the islands debt obligations. The S&P Municipal Bond index eked out a minuscule gain on Monday, the same day that ten-year government bonds of Italy, Spain and Portugal rose 24 to 34 basis points on Grexit fears. Yet that was nothing compared with the 387-point surge for Greek bonds. Meanwhile, German, French and Dutch yields fell as investors sought safe havens.
As for China, although the government is struggling to safely deflate a real estate bubble and banks, companies and local governments contend with lots of bad debt, the economy is still growing 7 percent a year, according to official data.
Of course, all this doesnt mean global financial markets are in the clear. A six-and-a-half-year stretch of ultralow interest rates globally has turned many investors into huge risk-takers, boosting assets ranging from Indian stocks to U.S. high-yield bonds. With asset prices at such high levels, it may be easy to set off a global conflagration.
The fact that many markets remained stable after Greeces bailout impasse this past weekend is reassuring. Of course, after U.S. investment bank Bear Stearns nearly collapsed in March 2008, the stock market didnt begin to plummet in earnest until May.
Its easy to imagine that sell-offs in Chinese and European stock markets and the U.S. muni market could spread to other, seemingly healthier markets, sparking a global sale of risk assets. And, of course, if investors rush for the exit all at once, market meltdowns are a real possibility. Thats not the baseline scenario of most mainstream analysts, who, like El-Erian, acknowledge that the risk exists but remain relatively sanguine.
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