How the Euro Debt Crisis May Impact You

Europe may be thousands of miles away, but its debt troubles weigh heavily on US markets. Remember the uproar that ensued when the U.S. lost its coveted AAA- credit rating this August? Well, watch out: credit-rating agency Standard and Poor’s decided last night to put 15 of the 17 European countries that share the euro currency on “negative credit watch” (financial speak for “50-50 chance we’ll downgrade you soon”). But does the credit crisis in Europe mean anything for investors here at home? You bet.

You might have noticed the value of your 401K or mutual fund bouncing up and down more than usual. (In September and October you probably saw it fall hard, only to see it rally in November.) You can thank the troubles in Europe for a large part of this volatility. Even portfolios with few European holdings may see wild swings, since uncertainty in Europe feeds into doubts about much of the world’s economy.

Europe’s Got Issues

It’s no secret Europe has a debt problem. Several of the nations that share the euro currency have rung up tons of debt in the last few years. It’s a simple problem, really: they don’t earn enough money (through taxes) to cover their expenses. Take Italy, for example: Its debt of 1.9 trillion Euros is equal to 120% of all the goods and services it produces in a year! Investors are nervous that the Italians might one day just give up and default on their loans, so they are requiring them to pay more in interest to borrow money. But that just makes things even harder for Italy, since higher interest rates make it harder to pay down the debt — and that makes it even likelier that they’ll default. Ouch.

Standard and Poor’s (S&P for short) is one of three major credit rating agencies who assign a risk level of the bonds issued by a country or company, creating a rating score(AAA is the highest score, representing the lowest risk). The higher the rating, the lower the interest rate paid. It is just like your credit score: You will normally pay less interest on your credit card if you have an 800 vs 600. (Have you updated your credit score on Mint.com yet?)

Yesterday, S&P threatened to lower the credit ratings of 15 out of the 17 members of the eurozone (the other two members, Greece and Cyprus, are already in trouble).  S&P wants the eurozone to come together to solve the structural problems with the common currency. If they don’t, then everyone will suffer. So even countries like Germany and the Netherlands, which have a relatively manageable debt load, could now stand to lose their AAA rating — something that the market hadn’t anticipated.

European Contagion?

Stock and bond markets around the world are more interconnected today than ever before. There is a fear that an S&P downgrade could cause investors to abandon the European debt market, which would not bode well for the continent. If the Europeans fail to solve their problems, the common currency could collapse, throwing Europe into recession — which would have repercussions here at home. For example, companies in the US that do business in Europe could see their orders dry up, forcing them to lay off workers. That could start a chain reaction, eventually pushing our economy into the dumps!

News of the potential downgrade caused stock markets in Asia and Europe to fall this morning. Here at home, stocks opened lower. While the fundamentals of those companies haven’t changed, the market fears that a possible recession could wipe out their future earnings. That means your stocks are probably down today. If you have a mutual fund, chances are it is down today because a lot of mutual funds invest only in stocks. If you invest in electronically traded funds (ETFs) to get some exposure to the hot commodity market, you too are seeing red.

S&P will be watching what happens at a critical meeting of European leaders scheduled for this Friday in Brussels. If S&P is happy with the solutions the Europeans come up with, they will leave the ratings alone. But if the Europeans fail to live up to their expectations, they’ll likely be downgraded. If you want to know where your stocks are headed in coming weeks, you might want to brush up on your French.

Cyrus Sanati is a frelance financial journalist whose work has appeared in dozens of leading publications, including The New York Times, BreakingViews.com, and WSJ.com. Follow Cyrus on Twitter @csanati