You'd be hard-pressed to find a market forecaster who included Egyptian riots in his or her predictions for 2011. But now that story is dominating the news, and as many investors found out last Friday when the Dow Jones Industrial Average plummeted 166 points, it's also affecting their portfolios. That market jolt, triggered by events in Egypt, may have many investors reevaluating their portfolios and the way they look at risk.
With that in mind, here are four of the biggest issues investors face in today's market:
Unrest in the Middle East. Egypt ranks 27th in the world in total oil production and it only makes up a small part of the global stock market, but the effects of the country's continuing riots have been felt in the U.S. stock market and oil prices. The reason is two-fold. "About 1.3 million barrels of oil go through the [Suez] canal every day," says Brett Gallagher, deputy chief investment officer for Artio Global Investors. "That's about 2.5 percent of the world's supply."
Also, Egypt shares a border with Israel and isn't far from other oil-rich nations like Saudi Arabia and Iran. The concern is that violence in Egypt could spread to nearby countries or a more radical regime could take over power in Egypt. "It's not so much Egypt," says Bob Gelfond, CEO of MQS Asset Management. "It's what could happen to the region in general."
Lingering debt problems in Europe. For the most part, the problems of debt-ridden European countries like Ireland and Greece, which have both been forced to take bailouts from other members of the European community and the International Monetary Fund, have escaped headlines recently. Many experts say this lull will probably be short-lived because long-term solutions haven't been put into place in these European countries. "All the so-called solutions have really just addressed the immediate problems symptoms of the problem, not the problem itself," Gallagher says. "Mathematically, it's very hard to see how they will be able to extricate themselves from this without some sort of default or debt haircut being taken."
Late last month, the Irish Central Bank lowered its growth forecast for 2011 from 2.4 percent to 1 percent, after the government instituted stringent austerity measures. In addition, on Wednesday, Standard & Poor's downgraded Irish sovereign debt for the third time in six months. Eventually, Gallagher says Greece and Ireland will either be forced to default on their debt or take what is called a "debt haircut"—meaning investors in the countries' bonds would be forced to take some loss on their principal. That could have far-reaching affects across Europe's banking system, Gallagher says, because many nations in Europe have exposure to these countries' debt.
Soaring inflation rates throughout the world. Federal Reserve Chair Ben Bernanke is one of the few global leaders who has said recently that deflation is a larger problem in his country than inflation is. That's why the Fed initiated a second round of quantitative easing—commonly referred to as QE2—in November, in which it's buying up $600 billion in long-term treasuries in hopes of pushing interest rates lower, spurring lending, and jumpstarting the economy. Other nations including China, India, and Brazil have complained that surging food prices and inflation are becoming a major problem. Part of the reason, they say, is that the Fed's quantitative easing program is eroding the value of the dollar. Many commodities like oil, wheat, gold, and corn are all priced in dollars because the dollar is known as the world's reserve currency. "If you're weakening the dollar, the dollar price of commodities is going to rise," Gallagher says.
Inflation remains low in the United States for a number of reasons, including the weak state of the housing market. Housing makes up 42 percent of the total Consumer Price Index (CPI), and it's currently inflating at a rate of virtually zero. Food only makes up about 15 percent of the CPI in the United States, but in emerging countries like China and India, it makes up a much larger amount—33 percent and 47 percent, respectively. That's because generally, in poorer countries, people spend a greater percentage of their income on food. That has central banks in nations like China, Brazil, and India raising interest rates in hopes of taming inflation. Gallagher's concern is that higher interest rates will lead to lower levels of growth in emerging markets. If growth slows in those countries, a selloff could occur, he says.
Massive redemptions in the bond market. Redemption risk—the risk that a large number of investors in a particular sector will decide to sell—is something investors should be aware of. Over the past few months, municipal bond funds have seen massive outflows over growing concerns that many state and local governments are overstretched and won't be able to fulfill their obligations. Since the start of 2007, muni bond funds have seen inflows of about $120 billion, according to TrimTabs Investment Research. "A lot of money has gone into municipal bond funds up until really November," says Vincent Deluard, executive vice president at TrimTabs. Since November, investors have pulled about $34 billion from these funds. The past three months have seen steady outflows.
Marilyn Cohen, co-author of the upcoming book Surviving the Bond Bear Market, says investors in bond funds should be aware of redemption risk. Investors in muni bond funds have seen how quickly a selloff can occur, and Cohen says it could happen in other types of bond funds, including corporates and emerging market bond funds. She sees a bond bear market ahead, in which interest rates rise regardless of the Fed's moves. In that environment, many investors would suffer losses they wouldn't typically expect in a bond fund. "It's coming because we haven't excepted fiscal prudence either as a country or as individual states, for the most part," Cohen says. In recent months, interest rates have slowly moved higher. Since the Fed's QE2 announcement in November, the yield on the 10-year treasury has risen a full percentage point, to 3.5 percent. Cohen warns that this is just the beginning.