In the last few weeks, Greece has taken the center stage in the financial markets. Within the next two months, Greece has to pay back the maturing bonds [to investors across the world] and finance its budget deficit. The country needs to borrow around $ 40 billion from the international markets. With 10 year Greek Government bond interest rates of  around 7% [more than 3% to 4% higher than 10 year U.S. Treasury Bonds and German Government Bonds], this has led to fresh worries over a potential default by the Greek Government. What has added to the problem over the last two days is a rapid withdrawal of deposits from Greek banks by its citizens. Unless Greece agrees to the terms set forth in the rescue package put together by the European Union and IMF [ to reduce government spending and increase taxes], it is difficult to get the support of this consortium to raise the $ 40 billion to stave off the crisis. As you can see from the graph, Greece’s debt is over 111% of GDP. We believe the situation in Greece is getting grimmer day by day and could be a trigger for a crisis in other European nations – Portugal, Italy and Spain.

The China Bubble

The fiscal stimulus initiated by China last year through bank lending to the tune of $ 1.2 trillion has led to potentially unstable conditions in their economy. According to well known investor James Chanos – with 60% of the country’s GDP relying on construction, ‘China is on a treadmill to hell’. Marc Faber a long time optimist on China and well known economist Kenneth Rogoff have also spoken of a China Bubble recently. With the Chinese government trying to enable a slow down in real estate speculation via a recent tax on sale of homes owned less than 5 years, one cannot rule out a rapid decline in prices which would have a negative impact on the economic growth.

Any one or combination of the two global factors identified above could trigger a mild to deep correction in the financial markets and slow down the world economy. Due to the strong financial linkages with the U.S. and the rest of the world, India will not be spared.

Srinivasa Sharan contributed to this article.

Graph Source : DNA

In September 2008 the failure of investment bank Lehman Brothers set off a negative domino effect across various asset classes with the exception of US Treasury Bonds and Cash. The bedrock on which Asset Allocation rests – different asset classes perform differently at various times in an economic cycle was undermined. This meant that conventional Asset Allocation also had to include some form of insurance which was guaranteed to perform well in a market crisis.This could have been in the form of deep out of the money put options on the stock market benchmarks which would have protected investors from the severe losses they experienced (similar to protecting another valuable asset – an automobile).

Investors must also focus on moving from a framework of Static Asset Allocation (i.e predetermined allocation percentages across asset classes) to Dynamic Asset Allocation. This would involve setting a wide range for Asset Allocation to particular Asset Classes with some form of valuation/ economic cycle based method to move to the lower or higher end of the range. For example if it were determined that an investor needs to maintain a 60 percent allocation to Equity, on the basis of where the market was trading on a historical valuation basis, Equity Allocation would be higher at 70 percent (if the market were trading at low valuations) or 40 percent (if the market were trading  at high valuations).

The third update on Asset Allocation would be to also evaluate concentration of Assets in particular sub- asset classes and make changes in these exposures to reduce portfolio risk. To follow up on the previous example this would be akin to reducing investments in Banks or Financial Services companies when there is an increased likelihood of an economic recession with a commensurate increase in investments in defensive FMCG companies. In Debt Asset Allocation this is akin to reducing investments in corporate bonds and increasing investments in Government securities on expectations of an economic slowdown.

To conclude while the market crisis of 2008-09 has prompted a review of Asset Allocation, we believe it still works in an updated form.