The Greek vote over the weekend was a little surreal. Greeks were asked to vote on an offer from Greece’s creditors that technically had been withdrawn prior to the vote. Regardless, Greeks voted by an overwhelming margin against the proposal, and this was taken as a repudiation of the bailout offer and an endorsement of the existing government under Alexis Tsipras. This throws the entire Greek situation into turmoil, not the least of which are serious questions about the viability of the Greek banking system and Greece’s place in the eurozone.
When the markets opened on Monday morning we saw a predictable knee jerk response. Stock markets in Europe sold off by between -2% to -3% while government bond yields in Germany and the U.S. fell (prices increased). However, by mid-morning equity markets in the U.S. were only down fractionally. What should investors take from the weekend’s events? We outline our views below.
Two Immediate Problems – Greek Banks and a Looming ECB Payment
Even prior to this weekend’s vote, the situation in Greece was precarious. First, a week ago all the banks were closed and capital controls were placed on the economy to try and stop a potentially disastrous bank run. The European Central Bank (ECB) had essentially said it would no longer expand its support for Greek banks leading to the emergency measures.
Second, Greece owes the ECB 3.5 billion euros on July 20th, and they don’t have the money to pay. What is interesting about the Greek debt situation, though, is how little of it is owed to the private sector. As you can see below, 60% of the debt is owed to the eurozone, another 10% to the IMF, and 6% to the ECB. Only 1% (3 billion euros) is owed to foreign banks.
So this isn’t like Lehman Brother’s where the failure of one entity will take down the entire global banking system. The bad news, however, is that the Greek’s can’t afford to default on the ECB. They need the central bank to solve their first problem. So how do they get the money to pay the ECB so the ECB can inject money into the banks?
Late Night Negotiations
On Sunday night after the crucial vote Mr. Tsipras said he has two priorities. The first is to re-open the banks as soon as possible. The second is to resume bailout negotiations, this time putting on the table the contentious issue of restructuring Greece’s debt burden. Germany and the rest of Europe have steadfastly refused to consider debt restructuring. Even southern European countries with debt problems of their own resist the idea. Both Spain and Portugal have elections coming up later this year and they do not want to give their left wing opposition a boost.
Tsipras probably thinks he now has a mandate to deal with his European counterparts and that they will be more willing to negotiate now that outright default looms. But his confidence may be misplaced. He probably needs a bailout more than Europe needs Greece. And critically, how willing will the Europeans be to negotiate? To quote The Economist:
“..after (Tsipras’s) anti-European blasts during the campaign, eurozone leaders, who will hold a special summit on Tuesday to discuss Greece, may prove unresponsive. On Sunday night, Jeroen Dijsselbloem, the head of the Eurogroup of finance ministers, called the Greek vote “regrettable.” In a letter to the membership of his Dutch Labour party earlier in the day, he said he hoped that “honest politicians” would step forward to tackle Greece’s deep-rooted problems—a formulation that made clear the contempt in which Greece’s current government is held by many EU officials, not to mention many of their countries’ citizens.”
There is clearly a strain of thought in Europe (particularly in Germany) that now is the time to eject Greece from the EU, if only to send a signal that there are consequences to economic mismanagement. Others are more open to negotiation and worry that letting Greece exit would set an unfortunate precedent for other struggling peripheral countries.
From Local Risk to Systemic Shock
So far the market reaction has been relatively muted. Certainly the surprise resignation of the Greek finance minister was taken as a sign that new discussions might be less contentious, but this view could quickly change. Our view on the markets over the next few days is as follows:
– Reaching a deal immediately is going to be tough. We suspect it will be hard for both sides to compromise, and parts of Europe may actually see this as a chance to put more pressure on Greece.
– The liquidity squeeze and resulting economic stagnation in Greece will intensify pressure on the Greek government to blink first. This fact increases the odds that ultimately some accommodation can be found that will keep Greece inside the Euro, although the political situation in the country will be fluid.
– It is quite possible the political situation in Greece deteriorates further. To quote Stratfor:
“…Tsipras will have to deal with an extremely complex political and social situation at home. The victory of the no camp will strengthen the most radical members of Syriza and weaken the moderates, constraining Tsipras’ ability to negotiate with the creditors. And while the no crowd won the vote, a substantial number of Greeks fear the result of the referendum will put the country closer to leaving the eurozone, potentially costing many Greeks their savings. So far, the Greeks are calm, but a collapse of the country’s banking sector and an exit from the currency union would almost certainly trigger street protests that could force the government to resign.”
– The key question for global investors beyond any near-term volatility is whether this is simply a local shock or something more systemic. Can Greece’s problems be contained or will they infect their European neighbors? Economically we don’t worry too deeply about Greece itself. While default and exit from the European Union would be very troublesome for Greeks themselves, the impact on the global economy should be pretty muted. Greece’s economy is tiny, only 2% of the eurozone economy, as you can see below.
– The bigger risk is what is called ‘contagion’. Will a potential Greek default/exit roil other markets in Europe’s periphery, namely Spain, Portugal, and Italy? If bond yields in these three countries explode higher it would signal that investors are betting that the problems in Greece are likely to spread. So far yields have increased in these three markets, but remain well below the crisis levels of a few years ago. The chart below shows yields on Italian 10-year bonds. Mid-morning on Monday they were trading at 2.39%. While off the lows of recent months, they are nowhere near the highs seen back in late 2011.
– If we start to see contagion in other countries we expect the ECB will be aggressive to prevent the flare up we saw in 2011. Unlike four years ago, the ECB is now committed to use its balance sheet to prevent systemic problems.
– Our bottom line is that we don’t see Greece as another Lehman shock, even under the worst case scenario of default and exit. The markets will almost certainly be very volatile and tied to the latest press release or rumor. But we struggle to see how Greece can infect the entire global financial system the same way Lehman’s failure led to a massive global recession. You can’t rule out a correction in equities, particularly given how long we have gone without such a selloff. But we don’t think Greece marks the beginning of a multi-month bear market.
– In terms of strategy, most investors with balanced allocations will see the benefit of such diversification today. While equities sell off, the bond side of the portfolio is making money. If we see dramatic losses in a particular sector we will take a hard look to see if opportunities are being created, but we doubt we will make allocation changes simply due to the Greek vote. This is because we doubt the vote will have a material impact on economic conditions or market prospects over the time horizon we are interested in (3 to 5 years).
These are our views in a nutshell today. We will be monitoring the situation closely and will adjust our take if the facts on the ground change.
Finally, please don’t hesitate to talk to your financial advisor about your portfolio and allocation if you are uncomfortable with your risk exposure.