1. ON OUR MINDS
What’s So Scary About
Greece, Doves, and China’s Standing?
Michael A. Tyler, CFA®
, Chief Investment Officer
June 19, 2015
As I walk through this wicked world
Searching for light in the darkness of insanity,
I ask myself, is all hope lost?
Is there only fear and panic and misery?
And each time I feel like this inside,
There’s one thing I want to know:
What’s so scary about Greece, doves, and China’s standing?
As I look back through 35 years of economic history, searching for light in the musty libraries of
old investment commentaries, I ask myself how Nick Lowe was able to capture today’s zeitgeist
way back in 1979 (with a few minor updates, I’ll admit). His yearning for hope in the face of
despair is as valid in today’s mostly favorable market climate as it was during the truly dark days
of double-digit interest rates, Arab oil embargoes, and economic malaise.
Perhaps it’s too strong to say that investors today have only fear and panic and misery. Yet when
I meet with our clients, I am frequently surprised by the pessimism that I encounter. In the past
six years, stock prices have tripled as our economy has emerged from a terrifying financial
meltdown and global recession. Today, we are in much better shape – really and truly, despite
our problems – and yet our clients still greet me with worry. This juxtaposition is jarring.
The concerns, to be sure, are legitimate: The list of potential bogeymen is long. Let’s take a
quick look at three issues that frequently top the agenda:
 Greece. As the country teeters toward default and possible exit from the Eurozone,
investors worry that the European economy and banking system may be thrown into
chaos that drives down stock prices abroad and here in the U.S.
 Doves. With stock prices so high and unemployment plunging, some investors think the
Federal Reserve’s extreme patience with low interest rates will put us at risk of an
inflation-fueled asset bubble and subsequent crash.
 China’s standing. As the world’s second-largest economy cools off, it’s possible we will
see a collapse in investment accompanied by a flood of defaults on the debt that fueled
China’s rapid expansion. Yet concurrently China’s expanding military aspirations and its
desire to be included in global market indices could threaten U.S. economic and military
supremacy.

2. June 19, 2015 © 2015 Eastern Bank Wealth Management 2
Greece
What if Athens has a crisis and no one panics? The Greek government owes far more money
than it can afford to repay with cash on hand, and its largest creditors are demanding satisfaction.
Step by step, each action by the principal parties has pushed this stalemate farther from
resolution rather than closer. Yet most of the potential outcomes are benign for global investors.
Greece is not insolvent, in that its assets still outweigh its debts and pension obligations. This is a
crisis of liquidity, not solvency: when you or I have debts we must repay, we may be forced to
sell assets or reduce our spending in order to raise the cash required to satisfy our lenders, and
we do so. Greece has mostly refused.
The creditors – the International Monetary Fund (IMF), the European Financial Stabilization
Fund (EFSF, set up by other European governments during the first Greek bailout), and the
European Central Bank (ECB) – are adamant in their demands that Greece reduce spending and
liquidate assets. Athens has made surprisingly good progress, so much so that the “primary
budget” (excluding pension payments) is actually in surplus. Yet the Greek pension system is
still overly generous, and the left-wing Syriza government has steadfastly refused to reform it.
Further, although Greece has agreed to privatize the port of Pireaus (one the great commercial
seaports in the world, a few miles south of Athens), no other major asset sales are on the table.
As a June 30 deadline for a €1.5 billion payment to the IMF looms, the best outcome would be
for the creditors to relax their demands, recognizing that they have been forcing Greece deeper
into recession, while Athens would agree to meaningful pension reform. At this late date,
political and personal exigencies may preclude a deal: neither Greek Prime Minister Alexis
Tsipras nor German Chancellor Angela Merkel want to appear to concede too much ground.
A more likely outcome is that Greece will miss either the IMF payment or a later obligation. If so,
the IMF has indicated it will immediately notify the EFSF and ECB, which will hold Greece in
cross-default. While this sounds rather technical, the implication is profound: The ECB is
backstopping the Bank of Greece to deter a run on the bank; yet depositors have already pulled
out almost €100 billion. If the ECB abandons Greece, Athens will likely have no choice but to
impose capital controls and limit cross-border trade, leading Greece deeper into recession and
inflation. All of this could happen with or without Greece leaving the Eurozone. 1
While the default scenario captures the headlines and causes the television pundits no end of
fear-mongering, global stock and bond markets suggest that this scenario will not trigger a global
crisis. Greek debt maturing in three years currently yields over 20%, anticipating a likely near-
term default; yet ten-year Greek debt yields only about 12%, as investors think that the Greek
economy will recover in time. Italian and Spanish bonds yield barely more than their U.S.
counterparts, indicating that contagion is considered unlikely. A default may embarrass the IMF
and slightly dent other European lenders, but it won’t lead to a bond market crisis.
1
We’ve seen this movie before. In Argentina and Mexico, the immediate pain of similar shocks was supplanted by
gains as the economy adjusted and a cheap currency invited tourists and investment. Mexico maintained discipline
and has a much stronger economy today; Argentina has allowed corruption and lack of discipline to undermine its
recovery several times in the succeeding years. It’s not clear which of these longer-term paths Greece might follow.

3. June 19, 2015 © 2015 Eastern Bank Wealth Management 3
Global stock markets, meanwhile, recognize that Greece is only a tiny part of the Eurozone and
an insignificant part of the global economy, so a deeper recession there will not meaningfully
affect corporate earnings in larger countries. More sophisticated measures of risk, such as credit
default spreads, likewise suggest that Greece’s political crisis and possible default would be
absorbed by global investors without causing a market crisis.
Doves
Turning to domestic issues, investors also worry that we are witnessing another asset bubble,
comparable to the dot-com mania of 15 years ago or the housing bubble of the mid-2000s. The
pessimists argue that the Fed has kept interest rates unnaturally low for too long, propping up
stock and bond prices while the real economy has stagnated. When the bubble pops, according to
this argument, our fundamental weaknesses (shrinking manufacturing, lack of productivity
growth, etc.) will be exposed and the Fed will be powerless to combat them. This argument rests
on the shaky premises that interest rates should be much higher today, and that low rates
necessarily lead to inflation. Neither of these premises is valid.
It is true that the U.S. economy could withstand higher rates. Output is growing, albeit slowly
and without much consistency. Unemployment has fallen sharply, and we are seeing some
pockets of wage pressure in high-skill jobs. Housing prices, especially in coastal urban centers
such as Boston, have been rising again. The drought in the west, combined with stabilizing oil
prices and higher housing costs, could be stoking nascent inflation. Higher interest rates would
dampen some of these trends, but wouldn’t necessarily affect corporate behavior with respect to
investment. In other words, the downside risk of raising rates is limited. Further, the banking
system is significantly over-capitalized, so higher rates would not threaten financial stability.2
Even so, there is a wide gulf between could and should. The Fed’s assessment of GDP growth is
now less than 2%, which leaves the economy vulnerable to exogenous shocks; indeed, a truly
healthy economy should be able to handle a few snowflakes better than ours has done in the past
two winters. While unemployment is down, labor force participation remains dismally low, and
it takes jobless workers far too long to find new work. Middle class incomes, adjusted for
inflation, remain stalled, as most of the last half-decade’s economic gains have accrued only to
the wealthy. In short, this expansion is still sufficiently fragile as to merit caution in raising rates.
This patience is further supported by developments abroad. As Europe and Japan struggle to
jump-start their economies with variations on the quantitative easing the Fed practiced here until
late last year, interest rates in those countries have been falling sharply; in just the past three
years, Spanish 10-year bond yields have dropped from 7.5% to about 2%. Short-term rates in
some countries are actually negative.3
2
In fact, one can argue that the Fed can no longer affect banking behavior through the Fed Funds rate. After several
years of tight credit standards and quantitative easing, the large majority of American banks have reserves on
deposit at the Fed that greatly exceed their regulatory requirements, so the market for inter-bank lending to meet
reserve requirements has essentially disappeared. In other words, the Fed Funds rate is largely irrelevant as a tool to
manipulate bank behavior, and its only significance is as a messaging tool.
3
In such instances, investors are effectively paying the Swiss government to safeguard their money, a strategy
aimed at capital preservation (and as a hedge against Greek default) rather than income.

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If the Fed were to raise rates here while the Bank of Japan and the ECB are cutting rates there, the
dollar would gain value relative to the yen and euro, much as it did through most of last year.
This could adversely affect American exporters, and the Fed is loath to allow the dollar to rise
too strongly lest it choke off our economic expansion.
For both domestic and international reasons, then, the Fed has significant incentives to delay
raising rates, and to be very gradual when it finally starts. That was Chair Janet Yellen’s message
in her press conference earlier this week, and it’s one that markets generally cheered. The
traditional risks of low interest rates – rampant inflation, overheating economic growth, job
shortages, asset price bubbles4
– are manifestly nowhere on the horizon. The doves on the
Federal Open Market Committee will continue to carry the day, but the hawks need not worry
that the end is near.
China’s standing
With a Trans-Pacific Partnership trade pact with Asian nations now in the headlines, many
investors have grown concerned that China’s evident slowdown and concurrent military
expansion could adversely affect the American economy. The argument here is that demand for
American exports to China will decelerate, which would cut into corporate earnings. Further, as
China reckons with a decade of overinvestment that has led to the creation of uninhabited “ghost
cities,” the debt that financed that investment may turn sour and ripple through the global
financial system. Could this be a repeat of the 1998 crisis triggered by Russia’s default?
There is little doubt that China’s economy has slowed meaningfully in the past few years;
reported GDP growth has decelerated from 10% a few years ago to around 7% today, and is
likely heading to 6% in the near future. Substantial skepticism abounds that these numbers may
be inflated by a government eager to show economic power; that’s less relevant than the
direction of change,5
which is clearly downward.
The slowdown isn’t surprising; it’s increasingly difficult to maintain high levels of growth as the
nation attains greater overall wealth. The same was true in the United States as we evolved from
an agrarian to industrial to information-rich economy. China is transitioning from an investment-
driven economy in the past decade to a consumer-driven economy today. Fixed-asset investment
is growing at its slowest pace since 2000, while retail sales are accelerating. This may hurt some
global companies (Caterpillar comes to mind), but it can also help others (e.g. Disney or Ford).
4
The stock market is currently trading at about 16 times year-ahead earnings, which is very slightly above its long-
term average, so it’s not cheap. But neither is it anywhere close to bubble territory, such as the 30x multiple it
touched in 1999. Market bears like to point to the Shiller P/E, which looks at earnings over the past decade, and
argue that it’s dramatically higher than its historical levels; well, yes, but so what? A stock market investor isn’t
buying past earnings and dividends, she’s buying future earnings and dividends. Moreover, the Shiller P/E still
captures the near-Depression earnings of 2008-09, while market prices today look to a future of sustained stable
growth. To me, it seems ludicrous to say that stock prices are dramatically overvalued. And while bond prices are
indeed expensive, the lack of any catalyst toward sharply higher interest rates suggests that they will remain
expensive for some time to come.
5
Math geeks will recognize this as the second derivative of GDP.

5. June 19, 2015 © 2015 Eastern Bank Wealth Management 5
The more worrisome aspect of China’s economic slowdown is the potential for the excesses of
an investment bubble to damage global financial markets. Most of that investment was funded
through debt issued by various state-owned enterprises, debt that likely can’t be serviced from
cash flows. It is unclear how much of that debt is owned outside China.
So far, China has done a masterful job of adjusting its financial system to handle the debt
problems, using a wide array of tools to avoid the credit bubble that sank the U.S. economy in
2008. These tools have included controls on the value and convertibility of the yuan, the ability
of foreign investors to participate directly in domestic stock exchanges, and the capital reserves
held by Chinese banks.
These capital-market activities are consistent with a broader view of China’s ambitions and
behavior. China has emerged as a legitimate world power, flexing its newfound muscle both
economically and militarily. It aspires to see the yuan adopted as a global reserve currency
alongside the dollar and the euro. It wants its stock exchanges to be included in global indices
promulgated by firms such as MSCI and Standard & Poors.
In order for China to realize these ambitions and become fully integrated into the global financial
system, it must cede some control over its currency and capital flows. It needs to increase
transparency, regulatory scrutiny, and international participation in its domestic capital markets.
Slowly and carefully, that is exactly what China is undertaking. As it does so, it is also finding
the way out of its investment bubble, again learning from the U.S. example. Beijing is
nationalizing some of the bad debt (as we effectively did with AIG) and using other entities to
absorb and properly price some of the rest (as the Treasury and Fed did by arranging marriages
between strong and weak banks, for example). While there may be disruptions along the way,
China’s record in this regard is generally quite good. The Middle Kingdom isn’t yet truly
standing as a full partner in the world’s financial system, but it’s getting closer.
As I walked on through troubled times,
My spirit gets so downhearted sometimes.
So where are the strong, and who are the trusted?
And where is the harmony, sweet harmony?
‘Cause each time I feel it slipping away,
It just makes me want to cry,
What’s so scary about Greece, doves, and China’s standing?
Nick Lowe had the right attitude: Greece, the Fed’s patience, and China’s transitional economy
may all be scary, but ultimately they are unlikely to threaten our economy or our markets.
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