July 2015: Greece!


1.  What’s going on in Greece?

On June 30th, Greece defaulted on a 1.5 billion euro payment to the International Monetary Fund (“IMF”) following an acrimonious series of negotiations in which Greece and its creditors postured, threatened and proclaimed their unwillingness to compromise further. 

Greece needed to work out a deal to extend or refinance existing loans with its primary creditors: the IMF, European Central Bank (“ECB”), and the European Investment Bank (“EIB”).  The alternative was default.  

Greece is a relatively small economy, comprising only 1.3% of the collective 28 European Union (“EU”) member states’ economy.  Its debt problem has been years in the making, becoming unmanageable in the wake of the 2008 financial crisis.  Greece has a heavy debt load (180% of GDP) in comparison to its economic output.  Restated, their debt is large and unsustainable relative to their means to pay the debt.  

Few observers of the five-year Greek/EU drama actually believed that Greece was ever going to be able to repay their debts.  Although smaller deficits were achieved by Greece through measures of creditor-imposed fiscal austerity, this also caused their economy to contract 20% —further eroding an economy already faltering under its crushing debt burden.

2.  After five years of financial assistance, why did Greece default now?

Early this year, Greece elected a new prime minister, Alexis Tsipras, elected on an anti-austerity platform.  He promised to reject additional fiscal austerity required by creditors. Of course, the most recent failed negotiations to extend the bail-out were predicated on even more fiscal austerity—this time requiring reform to Greece’s pension system. On July 5th, a nation-wide referendum confirmed the country’s rejection of more fiscal austerity.

For the last five years, Greece and its creditors have played a game of “extend and pretend.”  It works like this: creditors, primarily the EU and IMF say, “We’ll extend more credit to you so you have the money to keep up on your loan payments to us.  Then we can continue to pretend that our loans are good and you will repay us someday.”

The Greeks went along, agreeing to their creditors’ demands for a “plan” to make structural reforms—reforms that would theoretically create a Greek budget surplus by reducing government expenditures and increasing tax revenues.  Although Greece agreed to fiscal reforms, those changes never fully materialized. It has been a repetitive cycle of hope and disappointment.  Wash, rinse, repeat.

3.  What are the implications from Greece defaulting on their IMF debt?

When stiffed for a scheduled payment, the IMF’s by-laws prohibit additional loans to the defaulting debtor. The “extend” source of additional credit abruptly ceased. At the same time, depositors were withdrawing their money from banks as rapidly as they could, causing the banks to need more cash to keep their doors open. In response, Greece imposed “capital controls,” closing banks and freezing funds to stop a massive exodus of funds from Greece. 

The IMF default is not as much of an event as it is the beginning of a long, long transitional process. It’s reasonable to assume that without access to additional bail-out money, Greece will default on future debt payments to the IMF and ECB.  No one knows precisely how this will play out.  Although it is certain that Greece will continue to feel considerable economic and social pain, the fallout may be surprisingly uneventful for its international neighbors.

4.  Who are Greece’s other creditors and how much are they owed?

Greece owes roughly 313 billion euro ($350 billion) to its creditors.

Here’s the good news: “extend and pretend” provided a five-year reprieve from default, thereby enabling Greek debt owned by the private sector (mostly European commercial banks) to be shifted into the hands of government institutions (tax payers). Four years ago, European banks (outside of Greece) had €45.8 billion exposure to Greece; now, they have just €2.4 billion. Large losses that would have been devastating to commercial banks will now be incurred by government entities that can better tolerate such losses.   

5.  Could another bail-out deal be made?

A new plan, that is, a resumption of the “extend and pretend” game, is possible—but it won’t change the root problem: Greece is incapable of sustaining its debts. It would only kick the can a little further down the road.  So, why do that? The major benefit of postponing the inevitable day of reckoning has been accomplished; debt has been shifted from private hands to government hands.  Now, there’s no benefit to the creditors in throwing good money after bad.

6.  What would be the consequences of a Greece exit (“Grexit”) from the European Union?

Greece is between a rock and a hard spot. If they stay in the EU they will be required to endure more reforms and greater economic austerity. If they leave the EU, economic and social chaos are likely outcomes.   Without further injections of outside cash, Greek commercial banks will fail, commerce will shrink even further, contracts denominated in euro will be broken, Greece will lose access to foreign credit for at least several years, and a society plagued by high unemployment and depression will be ripe for even more social unrest. The EU may make an example out of Greece as a deterrent to other EU member nations, allowing Greek economic chaos and social unrest to run its course, without providing aid to ease their pain.

And, although Greece has a small economy (GDP of $238 billion), about the size of Louisiana’s, there will undoubtedly be more fallout.  In truth, however, no one really knows what that might look like.  What we do know is that international banking, commerce, and financial markets are highly interconnected.  What we don’t know is exactly how deep and extensive and critically interdependent the labyrinth of interconnectedness runs—or how the Greek default will or will not ripple through the labyrinth. 

In 2008, when the financial crisis erupted, there were unsettling surprises of financial interrelationships and interdependencies, especially in the complex world of derivatives.  The revelation of those interdependencies and their adverse financial impact were not well-received by financial markets.

"Only when the tide goes out do you discover who's been swimming naked." --- Warren Buffet

The larger concern—one that could have a significant impact beyond Greece—is the threat of so-called contagion.  Will other struggling nations, like Spain, Portugal and even Italy, see this as a precedent for leaving the EU?  In contrast to Greece however, those countries made plans to reduce their deficits and their plans were successfully implemented. 

7.  What does this mean to investors?

Whether the impact of Greek defaulting is minimal or significant, there are no plausible scenarios in which the near-term fallout will be positive for investors and the financial community.  If creditor losses have been contained to government entities, investors outside of Greece will not be impacted much. 

Greece defaulting is not a “Lehman moment” and will not serve as a catalyst for a global financial melt-down.  That’s good.  However, Greece defaulting is an entirely separate issue from a more overriding concern: valuations for stocks and bonds have been pushed to and remain at very high levels. 

As we’ve explained in our quarterly commentaries (available on our website), high valuations generally foreshadow below-average returns in the coming years.  Conversely, low valuations portend above-average returns ahead.  We wish it were different, but the math and a century of historical data confirm these truisms.

Our client portfolios, including our company pension plan, are invested conservatively with below-average stock allocations and above-average allocations to cash and short-term bonds.  With the benefit of 20/20 hindsight, we recognize we became defensive earlier than needed in this investment cycle.  But, we also recognize it would be disastrous for our retired clients to become defensive too late. 

As fiduciaries and guardians of your capital, we would be negligent to ignore history and its lessons.  Of course, we realize big gains are great fun. On the other hand, we also know that, in the words of sportscaster Vin Scully, “Losing hurts worse than winning feels good.”  

We can count on the certainty of investment markets changing over time.  With that, we can also count on there being a time when offense will replace defense. Until then, we will patiently continue on a prudent, conservative path with your and our investment capital.***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2015