Euro on the Brink

When the euro became a reality about 15 years ago, investors wondered how a plan to unite more than a dozen European nations using a common currency could help them prosper. Now, investors already worried about the U.S. stock market's recent turn are desperately looking for ways to avoid losing their shirts if the euro falls apart.

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Given the news of the past few months, it's not a stretch to think the euro's end is nigh. What would a worst-case scenario look like? Experts such as Simon Johnson, a professor at the Massachusetts Institute of Technology and a former International Monetary Fund executive, essentially envision a European economic Armageddon: bank failures, a continent-wide recession, trillions of dollars in European debt default, rampant inflation in Europe and, not to be forgotten, the end of the euro. Simply shunning European stocks might not be enough to protect a portfolio, if that disaster comes to pass. If the 2008 financial crisis taught investors anything, it's that global markets are interconnected, says Jeremy Glaser, a market strategist at Morningstar. There's no way to know how markets would react if Greece left the euro, he says, because "we haven't had a currency like the euro before."

Still, market strategists think the likelihood that one country after another will dump the euro remains remote. David Darst, chief investment strategist at Morgan Stanley Smith Barney, says that sort of "economic contagion" is doubtful because, if the euro value starts to go into free fall, central bankers in Europe, the U.S., China and Japan will all step in to support the currency. "All of these authorities would come up with this massive policy response to prevent contagion spreading to Spain, Italy or Portugal," Darst says.

But the once-unthinkable idea that Greece might leave the euro and return to the drachma -- called the Grexit by Wall Street wordsmiths -- has become a real possibility, experts say. Many Greeks have begun taking their savings out of local banks and depositing them in banks in other European countries, notably Germany. Still, some experts say, at this point, the consequences of Greece leaving the euro might not be all that bad for investors. European stocks are down about 7 percent since the Greek election in May, a shift that might already price in a currency switch. If Greece leaves in an orderly way, and the "rest of Europe rings it with a fence" so that investors feel protected against a wider foreign exchange crisis, then the markets can handle it, says Stu Schweitzer, vice chairman and global markets strategist at J.P. Morgan Private Bank.

But after the 2008 financial crisis, many experts are willing to believe that the worst is possible. If a Greek exit inspires a similar move by other countries struggling with debt, such as Portugal and Spain, then the entire European economy will suffer, Schweitzer says. That's when the dominoes could really start to fall. Individual investors have few good options to protect themselves against such a scary scenario. There's always running to the safe haven of U.S. government debt, but with the 10-year Treasury yielding 1.6 percent, near an all-time low, don't expect any great returns. Indeed, even today's low levels of inflation effectively wipe out the value of the interest a Treasury would pay. Also, speculating on the euro's value can be risky. Yes, the euro has fallen almost 20 percent against the dollar in a year, but even the pros can lose money betting against a major currency like the euro, which still has strong support from international investors. Central bankers can't afford for the euro to fail -- they, too, hold the currency.

Of course, there are some who see the European mess as a way to pick up stocks on the cheap. But for many investors, minimizing losses is the first priority. One way to reduce euro risk is to choose foreign stock mutual funds that hedge the currency exposure themselves. A simpler option: Own relatively few shares of companies that either trade on European exchanges or get most of their sales in Europe. J.P. Morgan Private Bank is recommending that clients take roughly half of what they would have invested in European stocks and instead put it in U.S. stocks or, if they're really fearful, cash. Darst says a good way to protect a stock portfolio from the bad economic winds in Europe is to tilt it toward domestic, defensive-style holdings like utilities, telecommunications and real estate investment trusts. If the euro continues to weaken, Darst says, the dollar value of the earnings that U.S. companies make in Europe will be worth less.