While European officials scramble to patch together some kind of bailout for debt-laden eurozone nations, it's beginning to look like the markets have already priced failure into the mix. Greek bond yields continue to soar to new heights while the yield on 10-year Italian bonds has blown past 7%, a level widely considered to be unsustainable over the long run. The eurozone is in a world of danger, and the global economy is already showing signs that it's beginning to crack under pressure.
Germany, one of the region's strongest economies, has seen its industrial production fall in recent months, while retail sales are falling across the eurozone, and the European Central Bank recently cut its key interest rate, warning that a "mild recession" was on the horizon. It remains to be seen whether the eurozone will indeed experience a mild contraction or whether a Greek or Italian default will set off a much larger financial contagion. Either way, the current state of affairs has some important implications for investors.
Danger zone
One sector of the market investors may want to think about avoiding right now is European banks. According to data from Reuters and the Bank for International Settlements, France has by far the largest exposure to both Greek and Italian debt, to the tune of roughly $55.8 billion and $416.5 billion, respectively. That's a lot of potential risk. So investors should exercise caution if they own shares of French banks such as BNP Paribas and Societe Generale. Both banks have been taking steps in recent days to pare their holdings of risky eurozone debt, so at least management is being proactive, but there is still a lot of risk here. Likewise, ETF investors might want to think about avoiding funds such as iShares MSCI Europe Financials Index (NYSE: EUFN) or PowerShares KBW International Financial ETF (NYSE: KBWX) that focus on this sector.
Similarly, at least in the short term, investors should be cautious about throwing too much money into Europe-focused funds. I don't think long-term investors should dump European stocks, but you should think twice about adding heavily right now to mutual funds or exchange-traded funds that invest exclusively in this region. Here, funds like Vanguard MSCI Europe ETF (NYSE: VGK) or iShares MSCI EMU Index (NYSE: EZU) might provide investors with more direct exposure to this region than most are comfortable with, so steer clear of narrowly focused funds like this for now.
Taking it all in stride
Of course, any investor should still have meaningful exposure to foreign stocks regardless of what short-term events may transpire in Europe. So even though I wouldn't necessarily recommend loading up on eurozone exposure right now, you also shouldn't feel the need to ditch your existing holdings. Instead, get your foreign fix through diversified funds or ETFs that don't have outsized allocations to European nations. Two to consider are the Vanguard FTSE All-World ex-US ETF (NYSE: VEU) or the Vanguard Total International Stock ETF (NYSE: VXUS), both of which devote roughly 30% of fund assets to developed European countries.
And while they come with their own risks and potential for high volatility, don't forget about the long-term earning power of emerging markets. In today's interconnected global economy, you're simply not going to find a corner of the market that is completely insulted from what's happening to the eurozone. But developing countries still offer a diversified way to approach foreign investing. Here, be sure to stick to broad-market funds, like the Vanguard MSCI Emerging Markets ETF (NYSE: VWO) or Schwab Emerging Markets Equity ETF (NYSE: SCHE), two of the cheapest emerging-markets fund options on the market.
There's no place like home
And although the events unfolding in the eurozone will absolutely have a big impact on the economy and on the financial and stock markets here in the United States, there's at least a decent chance that domestic stocks could weather the coming storm better than many of their overseas rivals. To build a strong defensive portfolio, investors should seek out high-quality, financially stable blue-chip stocks. These are the companies that should be best able to hold the line on profit margins, even if events in the eurozone usher in another global recession. So make sure you have a good handful of large-cap dividend-producers in your portfolio, or consider picking up an inexpensive exchange-traded fund that invests in a basket of these securities. For example, the SPDR S&P Dividend ETF (NYSE: SDY) will cost you just 0.35% and comes with a trailing 12-month yield of 3.3%.
The next few months will be interesting as the eurozone attempts to right its ship. At this point, it's hard to see how the current problems will be resolved short of a default from at least Greece and maybe Italy. But no matter what the next move is on the global chessboard, investors should be prepared for more volatility and some big changes in the very structure of the eurozone itself.
