Amazingly, the inevitability of Greek sovereign default has really been known for more than a year now but European political leaders have not publically acknowledged that they have received the memo. We have lost count of the short-term fixes they have tried over the past 12 months. Obviously none of them have provided lasting reprieve. We believe it would be in the best long term interest to ‘call a spade a spade,’ and allow a default to be the “solution”. However, we think that if Europe can create an ‘orderly’ default, the impact on the EU and world markets may be minimized.
Why is default inevitable? The reasons are fairly obvious, but the most obvious is the indisputable fact that, even if interest rates on Greek debt were reduced to 0%, they still couldn’t pay back the principal on its debt as it comes due. At the core, issues of corruption, tax-evasion, and excessive government employee compensation are so pervasive in Greece that a radical change in culture would be required for any lasting change to take place. We aren’t sure that has ever happened in history. Systemic problems simply can’t be changed quickly and thus short-term “solutions” will never truly be solutions. Additionally, the longer restructuring (i.e. default) is delayed, the lower the recovery rate will be.
So what is the likely impact on financial markets? It is difficult to say precisely because so much depends on accurately predicting European political decisions. The political options, as we see them, are:
- Continue to pretend that a new short-term “fix” will finally be discovered, magically morph into a systemic long-term solution and thus calm financial markets.
- Turn Euro countries into a “United States of Europe” entity whereby they not only share a common currency, but have a common Treasury and government (currently each government decides how much debt to issue for itself).
- Devise a plan for an orderly default of Greek debt with various plans to recapitalize European banks that own Greek debt and keep Greek default from moving elsewhere. Greek’s status as part of the EU thereafter would also then be a question mark.
As is probably obvious, the inevitable Greek default will have its greatest direct impact on the European economy. Much of the volatility in the US surrounds the uncertainty of how exposed US financial institutions are to the problem (which we think is manageable exposure due to increased capital since the 2008 crisis). The bigger concern for US markets is how a Greek default-induced European recession would impact the US economy? When added to US’ own slow down, it wouldn’t take much global economic weakness to tip the US economy into recession, if in fact, it is not already there. Since stock markets don’t like recessions, we view these risks as the greatest for intermediate-term impact.
As far as short-term reaction in financial markets, we believe this is largely dependent on which option Europe chooses. We would not be surprised to see #2 ten years from now, but there is no consensus for this approach among the European voting public and every country would have to be on board. This would take too long to have any impact on the current crisis. Option #1 would have the most detrimental effect on markets as eventually a disorderly default would be forced upon the politicians by freefalling equity and bond markets. Clearly, we view option #3 as the preferred option, though many details about the bank recapitalizations (private or public?) and contagion prevention measures would also need to satisfy markets. Assuming the details were sensible, we would not be surprised to see a substantial rally in equity markets following a Greek default. The tragedy of the Lehman collapse in 2008 was not that it did in fact occur, but that it was allowed to do so in a disorderly fashion. An better example of orderly failure was the bankruptcy process for GM and Chrysler. One could squabble with particulars, but the concept of organized bankruptcy had limited impact on the markets. There is no reason why Lehman could not have been or why Greece could not be similar. The difficulty in predicting is our less than expert insight into European politicians’ (really, any politicians’) rationale.
In the end, we believe the financial market’s response to Greek default need not be significantly negative, if for no other reason that the inevitably of default has been “priced in” for some time. The outstanding question is whether the default is of an orderly or disorderly nature. The former may actually produce a positive market reaction while the latter could result in a revisit of asset prices close to what we experienced in 2008 and 2009.