Perils of an Interconnected World

 | Nov 16, 2011 | 11:00 AM EST  | Comments
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The other night, I was chatting with the head macro trader from one of the world's best-known hedge funds. We shared our frustrations about the current market, and she told me she felt sorry for folks like us -- U.S. retail investors, that is.

In today's interconnected world, all of our portfolios are getting as complicated as hers and are now subject to the whims of political developments in tiny European countries that we've barely heard of.

A few weeks ago, the parliament of Slovakia briefly held up approval of the latest rescue package for Greece. In the end, the poor Slovaks (per capita GDP $17,889) were finally badgered into committing money to bail out the relatively rich Greeks (per capita GDP $27,875). I happen to believe the Slovaks have done a terrific job in bootstrapping their poor country by instituting a flat tax and attracting foreign investment. But you know the world is too interconnected when S&P 500 futures are affected by events in a country whose economy and population are fraction of that of Manhattan, south of Central Park.

That interconnectedness also highlights both the dangers and opportunities of the investment world's version of the "butterfly effect." You may recall that meteorologists first asked whether the flap of a butterfly's wings in Brazil set off a tornado in Texas. In the world of investments, this is better known as "financial contagion."

First, let's look at the dangers. While many investors are risk-averse regarding the euro zone's weak economies, such as the PIIGS countries -- Portugal, Ireland, Italy, Greece and Spain -- other countries outside the euro zone are also starting to fray at the edges. Hungary's currency, the forint, recently dropped to record lows against the Swiss franc and the euro, and the National Bank of Hungary had to pay up big time on its recent government bond auctions to keep the lights on in Budapest.

You might wonder what the fate of economy like Hungary -- about the size of the economy of Minneapolis -- has to do with U.S. retail sales or the U.S. unemployment rate. But that's where the butterfly effect kicks in. Once investor sentiment hits a tipping point, it's like shouting "fire!" in a crowded theater. Panic ensues, and everyone heads for the exits at once.

Second, look at the opportunities. Dangers on the fringe cause capital to flee to the center. Recall what happened during the fall of 2008. Global equity markets tumbled, while safe-haven assets such as U.S. Treasuries and the U.S. dollar soared. And as much as U.S. investors suffered, U.S. equity markets were among the best-performing stock markets of the year.

With the U.S economy showing signs of an upswing, and global economies from China to Hungary teetering for various reasons, the big surprise over the next six months may be that U.S. assets -- stocks, bonds, real estate -- will turn out to be the stars of the global investment scene. And that's yet another reason to be (relatively) bullish on U.S. stocks.

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