The situation with Greece has become increasingly unpredictable and could trigger further market volatility in the weeks ahead. However, even under an adverse scenario such as a Greek exit from the Eurozone, other European assets are likely to eventually resume their decoupling from Greek assets, given firewalls in place and a more favorable economic backdrop.
Following months of tortuous negotiations, talks broke down this weekend between European authorities and Greece over extending its bailout. Greek Prime Minister Alexis Tsipras has now called for a public referendum on July 5 regarding “troika” demands for fiscal targets and debt sustainability. In the meantime, the European Central Bank (ECB) has cut off Greek banks from further liquidity assistance. What will occur after this point is highly uncertain. For now polls show the majority of Greeks favoring an agreement, but the government is expected to campaign for a “no” vote and it is unclear how voters will respond to the technical nature of the ballot questions.
The inability of the troika and the Greek government to come to terms reflects specific as well as more general disagreements. On one level, the specific amount of primary surplus is important as it speaks to how much money is available for debt servicing. However, at another level Syriza believes the current Greek debt burden is simply not sustainable and the detailed negotiations over topics such as the amount of tax on theatre tickets miss the forest for the trees. For its part the troika questions whether Syriza will honor any deal given its increasingly antagonistic rhetoric and a history of missed targets, and is reluctant to send a signal to other profligate spenders that they too might benefit from debt haircuts or easing of fiscal targets.
Recent events represent a significant escalation of the crisis, but some context is required. The current Greek debt crisis has dragged on for over five years, and the breakdown of talks between the troika and various Greek administrations has been a recurring event. Debt restructurings—defaults by another name—have already occurred several times. The big problem for Greece is not so much that its debt/GDP ratio continues to rise despite massive reductions in government spending, it is that the business and household sectors are also in retreat and overall GDP has shrunk by over 25% in recent years.
The good news, if one can call it that, is that a prolonged crisis has allowed ample time for private investors to reduce their exposure to Greece. For example, while the troika has around €260 billion of exposure to sovereign debt, private sector creditors have a fraction of this amount. Similarly, the exposure of foreign banks to the Greek private sector is around €30 billion, and the Greek equity market capitalization has shrunk to around €13 billion. Moreover, the passage of time has allowed Eurozone authorities to put in place firewalls to limit contagion from a potential sovereign default through the recent expansion of the ECB’s quantitative easing as well as the creation of a pan-Eurozone bailout facility and banking regulator. While uncertainty and austerity have contributed to the Greek recession, economic data from other former bailout recipients has been much more encouraging.
The market has had just 48 hours to react to the weekend’s news, and the response thus far has been measured. After an initial sell-off, the euro actually strengthened against the US dollar, hardly the response one would expect if Greek contagion meant capital flight from the Eurozone. Eurozone equities did drop 3.8% on Monday, but this should be viewed in light of their strong 14% year-to-date gain. Peripheral sovereign bonds did suffer small losses (the yield on the Italian ten-year government bond rose 20 bps on Monday), but these merely represented the reversal of last week’s gains and suggest the ECB’s implied support is working as intended.
Looking ahead, uncertainty over everything from how Greeks will vote to how the result will be interpreted will continue to generate a dark cloud over Greek assets and may cause the few investors that retain exposure to cut their losses. Volatility may also spread to other asset classes like peripheral European sovereign bonds if losses on Greek assets trigger forced sales by leveraged investors. Still, we continue to believe that other European equity and fixed income markets should eventually resume the decoupling they have displayed from Greek assets in recent years, and a widespread sell-off could in fact represent a buying opportunity for long-term investors. Events like those unfolding now should serve as a reminder to investors of the importance of a well-diversified portfolio that allows them to withstand volatility and take advantage of any opportunities that may arise.
Wade O’Brien is a Managing Director on the Cambridge Associates Global Investment Research team.