As a wise man by the name of Yogi Berra once said, “It’s déjà vu all over again.” This is how investors feel about Greece at the moment.
2011 was the year of risk on / risk off. Virtually all risky assets—including stocks, commodities, energy, non-Treasury debt, and non-dollar currencies—rose and fell together based primarily on the macro news coming out of Europe. And by “Europe” I mean “Greece.” The fear among investors was that a Greek default would be the straw that broke the camel’s back, that seemingly insignificant incident that would put into motion a chain of events that would rip the Eurozone apart.
First, it would be Greece; then Italy. And next, the European Union itself. Crisis was averted mostly due to the actions of the European Central Bank. By offering virtually unlimited liquidity to Europe’s banks, the ECB ensured that a sovereign debt misstep would not lead to a “Lehman Brothers moment” in which the failure of one link in the chain caused the entire machine to stop functioning. A default, were it to happen, could be contained. Additionally, a negotiated settlement in which Greek bondholders would agree to take losses and the Greek government would agree to get its fiscal house in order took the risk of a Greek default off the table…at least for a little while.
Alas, it wasn’t meant to last. Two months into 2012, Greece is in the headlines again and sending ripples of volatility through the capital markets. The country’s European creditors demanded that Greece get serious about its economic reforms and make deep cuts to government spending (“Hey guys, for real this time. We mean it.)
In response, Greece’s largest police union threatened to arrest officials from the European Union, European Central Bank, and International Monetary Fund.
The arrest warrants are not being taken seriously, and frankly neither is Greece. After hysterical theatrics worthy of an ancient Greek drama, the Greek parliament approved the new austerity bill. The parliamentary breakthrough means that the planned debt haircut should happen on schedule and that Greece should be able to make its next major bond payment due in March. But few really expect the Greeks to deliver on their promises, and virtually no one considers the Greek crisis to be “resolved.”
Let me be clear on something: Greece will eventually default. Even if the “voluntary” debt haircut is implemented as planned, the country cannot balance its budget. No private creditor would be crazy enough to lend to Greece, meaning that the country will be at the mercy of its creditors at the European Union and IMF to pay its current bills. At some point, the EU and IMF will reach the point of disgust they should have reached years ago and will cut off their lending. When this happens, Greece will be officially bankrupt and will stop servicing its debts. The only two questions are “When will this happen?” and “What will the consequences be?”
On the first question, I am the first to admit that any estimate is at best an educated guess. I would certainly not be surprised to see it happen this year. European taxpayers are tired of subsidizing their irresponsible Mediterranean brothers, and political pressure is building to cut their losses and move on.
On the second, and far more important, question, the answer is a little more complex. I would expect a market reaction not too different from that of August of 2011 when Standard & Poor’s downgraded the United States’ credit rating. There will initially be wild volatility, but once investors figure out that the world is, in fact, still turning, life in the markets will return to normal pretty quickly. Banks with large exposure to Greek debts or large exposure to Greek credit default swaps may be forced into insolvency, but the ECB’s promises of unlimited liquidity to the “too big to fail” banks will prevent this from starting the dreaded domino effect.
And what happens to Greece herself? Abandonment of the euro is a real possibility, which would be followed by a domestic currency and debt crisis. Hyperinflation would be a virtual certainty, and Greek citizens would experience misery that makes the current austerity regime seem mild by comparison.
But then, the news wouldn’t be all bad. Locked out of the world’s credit markets, Athens would be forced to make some of the reforms that it lacks the political resolve to make today. It might—just might—emerge from the chaos as a more competitive country.
This is all just conjecture at the moment. For the time being, both creditor and debtor will continue to play their little game of understood winks and nods. And as long as both continue to keep up appearances, I expect most major world stock markets to enjoy a nice rally. Last week’s volatility notwithstanding, American, European, and emerging market stocks are all off to a great start in 2012. As Greece fades from investors’ attention, I would expect this rally to gain momentum. Position your portfolios accordingly.