The 3 Biggest Risks to Investors and the Economy

I found myself explaining my thoughts on the markets and the global economy to two different friends on the same day this week. "The markets have done surprisingly well," I said, "at least until May. But there are three huge risks to the global economy, and that means three huge risks to the market." I tried to make these complex topics easy for my friends to understand, and I'd like to share my reasoning with you as well. I'll even offer a few good opportunities to resist any potential downturns, with the best sort of recession-proof dividend stocks on the market.

The slow death of the eurozone
By now it's no secret that Greece is circling the drain. It's been one of the most reliable headlines in financial news for the past few months: "Markets are [up / down] because [something] Greece." It's more often been down -- the Dow (INDEX: ^DJI  ) has lost 6% since the start of the month, when Greece held its latest elections.

Greece has been in the middle of a deep recession for some time. Gross domestic product, or GDP, has shrunk by over 12% from its 2009 peak. The American economy would have to shrink by $1.9 trillion from where it's at to match the Greek decline. Only one of Greece's last 15 quarters since the end of 2008 saw GDP growth, and even then it was minuscule. Unemployment remains horrendously high, the country's banks are losing depositors' trust, its politics are a running joke, and borrowing costs are higher than the interest rates on most credit cards. The National Bank of Greece (NYSE: NBG  ) has lost almost 80% of its value in the past year, and about 98% over the past five years.

Austerity has failed to produce any positive results, but there's little indication that eurozone leaders are willing to reconsider their strategy. With one tally putting the global costs of a Greek exit at $1.2 trillion, persistent worries are understandable. But we may be overestimating Europe's resilience.

The euro area is second only to the United States in terms of GDP, led by Germany, France, Britain, Italy, and Spain. Italy and Spain are widely seen as the next dominoes in line, and both recently fell into recessions. Britain's anemic post-recession growth stalled out earlier this year, and France is very close to slipping underwater as well. With four of the big five in dire straits, it shouldn't be surprising that eurozone growth as a whole has flattened.

A quarter of Spain's working citizens are out of work thanks to a deflated housing bubble and stifling government regulations. It risks bank runs as major banks continue to get hammered by bad debt, which would put massive pressure on the European Central Bank to offer a bailout or on Spain to leave the euro. Late last year, Italy's borrowing costs went beyond the 7% danger zone that's been followed by bailouts in three other eurozone countries. Its government debt is larger, as a percentage of its GDP, than any other large eurozone country, and larger than that of any bailed-out nation except Greece.

Many of these problems are just as endemic to their home countries as they are the result of broader European weakness. Throwing money at one problem might very well make another one worse, especially if there's little hope that the money will be repaid. After all, that money comes from the central banks of the eurozone's member countries. Taken all together, Europe's decline offers a source of fuel for another slow-burning problem…

China's hard landing
Countries in recession tend to import less. Something about a lack of money flowing around tends to make people buy fewer things. China exports more to the combined eurozone than it does to the United States, but that's not its only problem. A post-crisis credit boom could lead to bad investments that turn rotten, like the "empty cities" that have become a popular talking point for China bears. Many Chinese companies seem to be cooking their books or just flat-out lying -- can the government's numbers be any more trustworthy?

Whether true or not, the numbers have been declining since 2010, from a blistering 12% annual GDP growth rate to just over 8% in its most recent quarter. As a Chinese "hard landing" is often defined as sub-7% GDP growth, this is a source of concern. A number of secondary statistics -- including rail cargo volumes, bank loans, industrial production, and electricity consumption -- have all taken a turn for the worse in recent months.

China's been attempting to create a more robust internal economy to better withstand external shocks, but it's far from immune. A solar panel trade war with the United States isn't likely to help either country, and runs the risk of spilling over onto other industries as well. Punitive tariffs have had major effects on the global economy before, and many just happen to be enacted when they're most harmful. A weak economy can handle a trade war less ably than a strong one, as you might well expect. And America's economy has a significant weak spot of its own…

The fiscal cliff
Remember last year's debt ceiling showdown? It was high drama for political junkies, but a headache for everyone else. Investors felt the pain, too, as the worst drama coincided with a 16% drop in the Dow over the span of about three weeks. The ceiling was raised in the end, but not before the bill doing so wound up stuffed with some potentially unpleasant mandates.

Nearly $1 trillion is set to be sliced off the federal budget over the next nine years as a result of the debt ceiling deal. Defense and discretionary programs will be hardest hit, but the size of the cuts weren't enough for deficit hawks. That could be a problem going forward, since it looks like there may very well be another fight over the debt ceiling this year. If you thought the last one was a doozy, wait until you see what Republicans and Democrats will do in a high-stakes election year.

That's just the initial drop over the cliff, which hides the sharp, pointy rocks of higher taxes below. The Bush tax cuts are set to expire at the end of the year, as is a temporary payroll tax cut enacted two years ago. Higher taxes will help reduce the deficit, but they also siphon money out of a still-weak economy. The harsher the political fight to come, the more likely it is that we fall off. I wouldn't count on olive branch exchanges in the Capitol just yet.

What can you do?
There are always risks, and it's usually the ones you can't see that are the most dangerous. It's impossible to tell just how much any of this is "priced in." At the same time, there are two things you can do: be on the lookout for buying opportunities, and move some money into steady dividend-paying stocks backed by business models that can survive any recession.

Philip Morris (NYSE: PM  ) , despite its European exposure, has one great trump card: Its customers are addicted to its products. Diageo (NYSE: DEO  ) is in a similarly enviable position as a purveyor of alcohol in troubled times. People may not go out to bars, but few are likely to give up alcohol entirely. Both companies should hold up well in any downturn, as should the dividend-paying stalwarts in our most popular free report. Find out more about the nine rock-solid dividend stocks that can secure your future in good times and bad. Claim your free copy now.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights. Motley Fool newsletter services have recommended buying shares of Diageo. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (14) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 31, 2012, at 7:40 PM, ijrshore wrote:

    Do you mean "China imports more from"; or "China china exports more to"?

  • Report this Comment On May 31, 2012, at 8:18 PM, TMFBiggles wrote:

    That would be the second one. I'll get the wording changed.

  • Report this Comment On May 31, 2012, at 9:00 PM, JohnMaxfield37 wrote:

    I have four and a half words for you:

    Long live Ludwig von Mises

    (I wasn't sure how to count "von," and thus the half)

  • Report this Comment On June 02, 2012, at 1:08 PM, LoadDrive wrote:

    The 3 Biggest Risks to Investors and the Economy are Government, Government, And More Government !!

  • Report this Comment On June 02, 2012, at 1:50 PM, mountain8 wrote:

    You forgot Government.

  • Report this Comment On June 02, 2012, at 1:56 PM, maxph wrote:

    "from where it's at"? Where were you educated Alex?

  • Report this Comment On June 02, 2012, at 3:25 PM, xetn wrote:

    I think the three biggest risk to investors is:

    1. Belief in government's ability to solve economic problems (they cannot and they keep proving it).

    2. Belief in central planning by central banks that think they can bail out anything by creating new money out of thin air (they cannot and they keep proving it).

    3. Belief that any group of people can foretell the future through any kind of math. (They cannot and they keep proving it).

    Only the a truly free market that believes in the law of contracts and private property rights and completely free, voluntary exchange can provide the best signals as to what Mises termed "Human Action" because there are billions (probably trillions) of independent transactions by individuals trying to improve their own personal positions (or relieve a felt unease as Mises spoke) without any influence by any government.

  • Report this Comment On June 02, 2012, at 3:37 PM, 1946dodge wrote:

    It appears to me that Europe has outsourced its manufacturing to China and now Europe is failing. I don't think Germany fell for that and they seem to be the only European country that is still afloat. We outsource to China and we are in trouble. It seems to me that everybody outsourcing to China for manufacturing is the problem. The fact that stuff made in China is cheap, people in Europe and the US would buy it cheap, and buy more than anyone needed, throwing items away when they broke (rather than repairing them). So we get an abnormal demand for Chinese goods, thus jacking up their manufacturing, and we get a huge polution problem throwing the broken stuff away. Now since many of these countries have no manufacturing abiilty and skill, many are out of work, relying on their governments to pay for them so they can buy more cheap Chinese stuff. Eventually the governments can no longer supply their unemployed with money so demand for Chinese goods plummets and now even China is trashed.

    Outsourcing is one problem. Abnormal gluttony and greed on the part of citizens and the companies of their countries that outsourced is the other. At least it appears to me to be thar way.

    1946dodge

  • Report this Comment On June 04, 2012, at 12:31 AM, jmpollo wrote:

    when the advice is to drink and smoke more, I start to worry... ;)

  • Report this Comment On June 04, 2012, at 2:20 PM, bronzeguy wrote:

    One of the main functions of 'government' is to keep the economic powers off the backs of the citizens. Thus the results we have of repealing the Glass-Stegal act which prohibited banks from leverging assets. The conservatives were all for G-S, the crowd now decrying 'government'.

  • Report this Comment On June 04, 2012, at 3:56 PM, TopAustrianFool wrote:

    "Austerity has failed to produce any positive results"

    What austerity? THey never had any austerity.

  • Report this Comment On June 04, 2012, at 4:00 PM, TopAustrianFool wrote:

    " A post-crisis credit boom could lead to bad investments that turn rotten, like the "empty cities" that have become a popular talking point for China bears."

    And also the pre-crisis credit boom that the Fed produced is also a source of a malinvestment and the sole cause of the Recession/Bust/Depression/Down-turn.

  • Report this Comment On June 04, 2012, at 4:04 PM, TopAustrianFool wrote:

    "Whether true or not, the numbers have been declining since 2010, from a blistering 12% annual GDP growth rate to just over 8% in its most recent quarter. As a Chinese "hard landing" is often defined as sub-7% GDP growth,"

    China is particularly vulnerable to malinvestment in capital illiquid assets that creat the worst depression during capital structure readjustment. China is so drowning in bubble markets like energy and housing that I don't think the communist party will survive past 2016. And definitely they are done by the end of the decade.

  • Report this Comment On June 04, 2012, at 4:08 PM, TopAustrianFool wrote:

    "The harsher the political fight to come, the more likely it is that we fall off. I wouldn't count on olive branch exchanges in the Capitol just yet."

    I would say the more the govt fight the less mischif they do with new laws, regulation and spending. Cut spending and only then you will allow for real savings which are the only source of investment capital that leads to true and permanent growth.

    And tell the Fed to stop stealing from US citizens by printing money.

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