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Greece - Drama or Tragedy?

Market Thoughts 06.28.2015

Events over the weekend will likely create market volatility to start the week. A chain of events, starting with collapse of Greek bailout talks on Friday to closure of Greece’s banks and stock market on Monday, have ushered in capital markets uncertainty. In this Market Thoughts, we discuss key points investors should be aware of heading into a news-flow-heavy week, a week that will determine whether the recent game of political chicken is merely drama or leads to detrimental investment outcomes.

The lead up to this weekend’s issues are pretty basic. Greece owes creditors for years of bailouts needed due to Greek government spending far in excess of revenue. Markets had anticipated that negotiations between Greece and the International Monetary Fund (IMF), the European Central Bank (ECB), and the European Commission, referred to as the troika, would resolve before the bailout program ends this Tuesday, the same day Greece owes the IMF 1.6 billion euros. Unfortunately, expectations were not met. Greece decided to hold a public referendum on components of a European bailout extension after the payment deadline. European leaders, in turn, withdrew their willingness to consider extending the bailout. This has left many Greek citizens worried about their bank deposits. The Greek government responded by restricting withdrawals and closing banks and the Athens stock exchange for at least part of this upcoming week.

What happens if a deal does not occur before the bailout program ends and Greece defaults on its bonds? Despite all the activity leading up to the bailout deadline, including tension-filled press conferences, political maneuvers, pontification from market pundits, and comparisons to recent history, no one knows the extent of Greece’s potential default. Even though investors expected a deal to materialize, should a last-minute kick save not emerge, capital markets are more prepared than in years past.

First, governments are the primary owners of Greek debt. Bloomberg reports that as of late 2014, the public sector owned 83 percent of Greek bonds.[1] That means banks outside of Greece will be less impacted than they would have been just five years ago, when markets worried that Greek bonds were spread throughout the market and would cause many banks to freeze lending. While markets may be on edge, banks are not as vulnerable due to better risk management around Greek borrowings. On a Sunday afternoon conference call, Credit Suisse noted the private sector had reduced its Greek debt holdings by more than 95 percent over the past few years.

Second, the ECB under President Mario Draghi has been much more responsive than during the 2010 and 2012 European market stresses. He committed in 2012 to do “whatever it takes to preserve the euro, And believe me, it will be enough.”[2] His point about preserving the euro is worth stressing. Many are speculating about Greece’s imminent departure from the European Union and the precedent it may set for other countries. Yet, even if Greece does leave the euro, which is by no means a foregone conclusion, the ECB will likely push forward with economic stimulus to maintain the European economy’s recent momentum.

Third, Greece is a small economy, with a gross domestic product smaller than Boston, MA, and its recent woes have been well documented. While Greece will feel even greater hardship pending the next few weeks’ outcome, economies dependent on Greek industry have already adjusted. One variable does give us concern: markets overreacting to the potential for a Greek exit from the European Union and speculation that this exit sets a precedent for other countries to follow. We still see the capital market environment as being a glass half full and believe Greek issues are contained, but we do not presuppose other investors feel the same way. Other scenarios could develop, and we will keep you abreast of a change in our views.

Market reactions have U.S. stock futures down a little over 1.5 percent and the euro weakening against the dollar. Government bond prices are higher (and yields lower). We are long-term investors, so short-term market fluctuations deserve comment, but not always action. We expect heavy news activity in the next few days. Should you have any questions about what this means for you or your constituents, please do not hesitate to let me know.

Onward.

Eric J. Freedman

[1] http://www.bloombergbriefs.com/content/uploads/sites/2/2015/01/MS_Greece_WhoHurts.pdf

[2] https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

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