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European Noise

I remain positive about the final outcome of the economic crisis in Greece. This does not mean that the country’s economy will return to health anytime soon, but rather that the potential for any long-term disturbance in the global economy is relatively small.

That being said, the situation in Greece reinforces that markets will punish irresponsible monetary policies and rising sovereign risk. Investors will gradually change their attitudes toward such profligacy, especially in regards to the world’s developed economies.

Once this shift occurs, fiscal policy will become more difficult to implement; financing debt will grow to be prohibitively expensive, as investors will scrutinize debt fundamentals more thoroughly while making fewer assumptions regarding potential bailouts.

As the US economy gradually improves, the new question is whether the economy will suffer from the slowdown in Europe.

Export-focused industries will bear the brunt, as Europe accounts for 26 percent of US exports. Growing demand from emerging markets will cushion the blow a bit, but US exporters will take a slight hit in the near term.

That being said, S&P 500 companies generate only 8 percent of their revenues, and less than 5 percent of US banks’ total assets are in Europe. Investors should assume that the impact will be manageable.

This is where Asia comes in. From an economic perspective, emerging Asia’s debt is around 35 percent of its gross domestic product (NYSEMKT:GDP); in the G7 countries (France, Germany, Italy, Japan, the UK and the US), the debt-to-GDP ratio has ballooned to 90 percent. The International Monetary Fund expects the G7’s debt-to-GDP ratio to reach 120 percent by 2014, while debt levels in emerging Asian economies could actually decline.

Consequently, what many investors have traditionally regarded as a high-risk economic block is gradually becoming one of the world’s most stable. True, there will be problems and misallocation of capital as the transformation continues, but for now Asian governments have a much better selection of tools to protect their economies during slowdowns and support their banking systems and funding needs.

As I noted in late 2009, Asia led the world out of the recession and will also be ahead of the curve in tightening accommodative policies. That being said, I expect Asia’s GDP to surpass 7 percent this year--depending on China’s performance, it may even reach 7.5 percent.

The selloff that commenced began Jan. 11 has brought equity prices down in a hurry as investors rushed to protect gains. In the Jan. 27, 2010, issue of the Silk Road Investor, A Fearful Market, I noted:  “Nevertheless, the market can overshoot on the downside; don’t be surprised if stocks fall another 8 to 10 percent. In this case, investors would enjoy another opportunity to buy into Asia’s long-term growth.” Asian markets often weaken in response to monetary tightening.

Asian markets are 8 percent lower than the January peak; investors with longer time horizons should continue to add to positions.

On the valuation side, Asia trades at around the long-term average of 1.8 times book and around 12.5 times forward earnings. These are not expensive valuations given this year’s growth expectations.

Yiannis Mostrous is Editor of Silk Road Investor and Associate Editor of Personal Finance.

Disclosure: no positions