Yet Another Greek Tragedy

Posted in: Economics, General, Stock Market, Thought of the Week

Once again, Greece has injected a large amount of volatility into global equity markets over the past month. They just cannot seem to alleviate their financial difficulties as their economy weakens, and the pains of austerity have inspired their citizens to recently elect a group of radicals who have made some very bold promises to their constituents.

The country has quite a history of causing disruptions in equity markets because they are often viewed as a stepping stone to bigger and scarier problems across the Eurozone. This concept of “contagion” is a very powerful force in financial markets because fear and panic can cause major corrections in asset prices in a short amount of time.

NOTE: The fear of contagion is one of the main factors behind the financial crisis in 2008. Once Lehman Brothers went down, markets violently reacted over concerns that other large financial institutions would fail.

Greece first scared investors back in 2010, when the major rating agencies downgraded their debt to a “junk” rating and ultimately required a bailout.

Contagion spread quickly into other weak economies in the Eurozone, particularly Spain and Italy, because these countries are much larger than Greece but were experiencing similar financial difficulties. A bailout in Greece was possible, but Spain and Italy were far too big to save, and investors were well aware of this scary truth.

A similar situation occurred during the first half of 2012, when renewed concerns over the future of the Euro currency sparked fears that Greece would leave the Eurozone and subsequently destabilize the region. Once again, contagion fears took hold.

Mario Draghi, the President of the European Central Bank (ECB), informed the world that he would “do whatever it takes” to prevent the Euro currency from failing. That single phrase was enough to eliminate the contagion risk, and the yields began to stabilize soon thereafter (indicating that investors felt that the risk of owning their bonds had fallen dramatically). This marked the end of the second Greek financial tragedy since 2010.

Since February 2014, we are seeing a new story. Whereas the Greek yield on the 10-year government bond has surged from below 6% to over 11% in a matter of months, Spanish and Italian yields have continued to fall dramatically.

The reason for the divergence is because investors see no risk of contagion this time around. This dramatic change in sentiment is due to three key reasons:

  1. Economic Differences: Despite the current threat of deflation in Europe, Spain and Italy have improved their economies since 2012, whereas Greece’s GDP has fallen dramatically over last year.
  2. Quantitative Easing (QE): The European Central Bank (ECB) will begin buying government bonds in the same manner as the Fed during their three rounds of QE. Spanish and Italian debt will most likely be included, however Greek debt does not meet the ECB’s requirements for purchasing due to their financial situation.
  3. New Leadership: Greece’s newly elected officials have no governing experience and are publicly attacking their creditors. Furthermore, they are threatening to end the austerity that they were forced to accept in their bailout, which could eliminate the possibility of future funding and lead Greece to default.

Simply put, financial markets are expecting the issues in Greece to be contained, despite the recent volatility we’ve seen in global equity markets.

The showdown in Greece appears to be a classic case of “brinksmanship”, which is a situation where two parties refuse to compromise on a highly critical issue until just before a deadline is reached. Publicly antagonizing those who bailed them out of their last crisis is not the best long-term course of action, particularly when they are weeks from running out of cash.

Furthermore, the rest of Europe will likely concede to some of the demands from Greek leaders to prevent a Greek exit from the Eurozone. Politics typically demand some form of concession in these situations, and it’s hard to see how Europe will benefit by a Greek exit.

However, the risk of a Greek exit does exist, and if they do ultimately leave the Euro, it’s tough to estimate the real impact to financial markets. The sheer number of variables and scenarios to analyze makes the task overwhelming with conclusions that are likely unreliable.

The bottom line is that the situation in Greece could get worse over the coming weeks, but the risk of contagion into the larger economies in Southern Europe is very low. Expect to see more volatility if the situation does not improve, which will only mean more opportunities to buy stocks that go on sale.

Read this week’s Thought of the Week to learn more about the current situation in Greece.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.