The Greek Paradox

A default by Greece is inevitable.  It is not a matter of if, but when.  And it appears that this final outcome may now be drawing near.

The problem for Greece all along has never changed.  Greece borrowed too much money.  Now they can’t pay it back.  In order to receive help from its European neighbors in the hope to eventually pay back these loans in the future, it is being required to raise taxes and cut government spending.  But both of these policy actions will cause growth in the Greek economy to slow even more, which further reduces their ability to pay back these loans.  In short, the problems only become worse over time, not better.

Yet policy makers have insisted on preventing Greece from defaulting for the last several years now.  Why?  Because a Greek default threatens to create a domino effect that could result in another global financial crisis.  This is due to the fact that many banks across Europe hold Greek bonds.  If these bonds become worthless, many of these banks may subsequently fail themselves.  And the Lehman scenario from late 2008 starts to unfold all over again.

The next key debt refinancing deadline for Greece is quickly approaching on March 20.  Negotiations have been ongoing for months now to ensure that Greece receives the latest round of bailout funds from Europe.  But as we draw closer to the breaking point for getting something done, the posture of European policy makers appears to be changing.  While Greek leaders continue to push feverishly with newly approved austerity promises, European leaders are responding with greater skepticism and complacency.  Given the urgency of the situation, this more relaxed stance suggests European policy makers are becoming increasingly resigned to the fact that Greece simply cannot be saved.  And instead of throwing more money at a situation that cannot be solved, perhaps it is time to just get on with it already and see what happens.

In many respects, global policy makers have been preparing for months behind the scenes for a Greek default.  Their focus has been setting up support for the banking system.  Back in late November, global central banks coordinated to opened up currency swap lines to ensure that at risk banks have adequate liquidity access.  Then in December, the European Central Bank (ECB) made collateralized loans for 3-years at 1% with virtually no strings attached to banks across the region that needed the funds.  And the ECB is set to do offer another round of loans at the end of February just in case any banks need to be topped off with liquidity and balance sheet support.  All the while, global central banks from around the world including the U.S. Federal Reserve continue their own aggressive monetary stimulus programs.  These are just some of the actions that have occurred recently that have the look and feel of a world that is getting ready for a potential shock.  Fully liquefy the system in advance, stand ready to act once the event strikes and hope for the best going forward.

The stock market has thus far been remarkably complacent in the face of this risk, rising seemingly every day and often without much of a reason.  This phenomenon, however, is also due to the ongoing distorting effects of monetary stimulus on stocks.  Put simply, the stock market becomes artificially inflated when liquidity is being injected into the financial system.  But the problem with this distortion is that the stock market quickly collapses once this artificial support is removed.  This was why the stock market corrected so sharply starting in late April 2010 and again in late July 2011.  In both instances, stocks were detoxing from the withdrawal of monetary stimulus.

At present, the stock market is once again elevating behind the influence of monetary stimulus, but this may not last for much longer.  This is due not only because stocks are now vastly overbought, but also due to the fact that stocks have shown the increasing tendency over the last year to decline swiftly and sharply even when they are still receiving the support of monetary stimulus.  Last year around this time it was Libya, Egypt, rising oil prices and the Japanese earthquake that sent stocks for a ride lower over several pullbacks in the spring.  This year, the unfolding situation in Greece may be the catalyst to spark the latest sell off.

So what can we reasonably expect from investment markets in the event that Greece actually goes into default in the coming weeks?  The answer here is far more nuanced than might be expected.

If Greece defaults, the initial stock market reaction is likely to be fairly muted.  An immediate sell off followed by an equally quick recovery is a very likely possibility.  It would not be surprising after the immediate reaction to even see stocks gradually rise in the subsequent week or two.  This is due to the fact that the financial system is prepared for a Greek default.  This is the event that everyone is watching and anticipating.  And it is directly around the Greece situation where all of the monetary levees have been placed.

Instead, it is in the aftermath of the Greek default where the true danger lies.  This is due to the fact that when a major market dislocation like a Greek default occurs, the spark for contagion typically arises from unexpected sources in the end.  When Lehman failed back in 2008, stocks did not collapse immediately.  Although they thrashed about in the initial days, it took three weeks before they started to fully cascade lower.  When Credit Anstalt failed back in 1931 during the Great Depression, the stock market sliced back and forth for over a month before falling off a cliff.  In both cases, this delay was due to the fact that the problems that eventually pushed the stock market lower emerged from sources well removed from what was perceived by policy makers to be the primary areas of concern.  And given the magnitude and complexity of the current crisis in Europe, there is no reason to expect anything different this time around with Greece.  Stocks may not go down immediately, but they may eventually get pulled sharply lower once the true fallout effects eventually start to surface.

Fortunately, the market is made up of a variety of asset classes outside of the stock market, and each will have its own unique response to a Greek default if it were to occur.  U.S. Treasuries would likely rally strongly as investors seek a safe haven from the crisis.  U.S. TIPS, Agency Mortgage Backed Securities (MBS) and Utilities Preferred Stocks would also likely rise under the same influence, albeit at a more measured pace than nominal U.S. Treasuries.  Precious metals such as Gold and Silver also provide a degree of portfolio protection.  If history is any guide, they would likely rally immediately on the default announcement, pullback sharply once the mass liquidation activity gets underway, and then rally even more sharply once global central banks intervene with even more aggressive monetary support in an attempt to address any fallout.

Of course, European policy makers may eventually relent in the end and postpone the inevitable Greek default to yet another day.  This is the reason to maintain stock exposures in the face of such risks even with a stock market that is already overbought.  For as long as global policy makers continue to pour more money into the financial system, stocks have the potential to continue rising far beyond reasonable expectations until the policy support is finally removed or the next crisis flashpoint (military action in the Middle East?) rises to the surface.  And just as the numerous categories outside of stocks provide support during a crisis event, most also stand to participate to varying degrees if stocks continue to move to the upside.

These remain interesting times.  And while 2011 was an eventful year, 2012 may be even more memorable when it’s all said and done.  It should be interesting to see how it all unfolds in the coming weeks.

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