This Greek Drama Will Have A Short Run
We do not see the current concerns over a Greek default or exit from the euro as posing a significant long-term risk to the markets. With a GDP similar to Louisiana’s, Greece is just not big enough to make a significant impact on the European or global economy. The main market risk from the Greek crisis is its potential contagion effect on peripheral European countries with high debt levels like Spain, Portugal, and Italy that might spread the crisis and threaten the broader European economy. To date, financial indicators are showing little evidence that this latest Greek crisis is spreading to the other peripheral Eurozone countries as they did in the 2010-2012 phases of the crisis. This is reassuring and reflects the strengthening of European bank balance sheets since then, their having gotten rid of most of their holdings of Greek debt, and the European Central Bank’s current program of providing ample liquidity to the European banks. We continue to see the stock market environments both in the US and Europe as favorable.
Twenty-five hundred years ago, Greeks such as Aeschylus, Sophocles, and Euripides gave the world hundreds of plays that have come to be known as the Greek Tragedies. The three dozen of these tragedies that survive provide us with insights into the human condition, especially into how our frailties, such as hubris, can be fatal flaws that can overwhelm our more admirable qualities. As we write this, the financial world is fixated on the latest Greek tragedy involving the hubris of an inexperienced leader of a bankrupt nation of little economic significance. While the classic Greek tragedies have stood the test of time, we think this latest drama will have little lasting effect on the world markets.
By way of background, Greece is a small nation of 11 million people representing less than 0.2% of the world’s population. Its economic significance also is trivial as its 2014 GDP totaled about $242 billion, equal to 0.4% of worldwide GDP. For perspective, Greece’s total output is similar to that of Louisiana or Iraq. Its economy continues to be based on small, family-owned businesses that are relatively inefficient due to the difficulties such businesses have in obtaining capital and skills for enhancing productivity. If Greece had its own currency, that currency’s value would have fallen to reflect this lack of productivity, and Greek goods would be cheaper for foreigners to buy, making them more competitive on the world market. But since Greece uses the euro, whose value reflects the greater productivities of the larger European nations, Greek companies find it hard to compete.
To provide jobs for its people, Greece traditionally has employed a quarter, or more, of its workforce in secure government posts offering very attractive salaries, early-retirement options, and generous pensions. In addition, tax evasion is a serious problem there. The combination of an inefficient economy, a bloated public sector, and poor tax collections has produced ongoing government deficits with Greek public debt having reached $366 billion in 2013, equal to 175% of GDP. For perspective, in their 2008 book, “This Time Is Different”, noted economists Reinhart and Rogoff presented data showing that a nation’s government debt historically has become unsustainable when it has exceeded about 90% of GDP. To make matters worse, Greece historically has looked to foreigners, especially European banks, to lend it the money to finance its deficits. When a nation owes substantial debt to foreigners and those foreigners no longer wish to finance it, the result usually has been a national default, a collapse of that nation’s banking system, and several years of depression.
In recent years, to protect the European banking system from a Greek default, other European government and international institutions have purchased most of Greece’s debt from Europe’s banks. According to Bloomberg, more than 80% of Greek government debt now is owed to the European Central Bank (ECB), the European Union, and the International Monetary Fund (IMF).
To avoid the painful consequences of default, in 2012, the Greek government agreed to a program of financial support with the European Union, the ECB, and the IMF in return for promises of economic reform involving shrinking public sector employment, reducing government pensions, improving tax collections, and private sector reforms to make the economy more efficient. This so-called “austerity program” was understandably quite unpopular with the Greek people. And to the extent that it was being imposed on them by the more financially disciplined Germans, it reawakened national animosities going back to World War II.
The reason the Europeans and the IMF were willing to continue financing Greece was that during this 2010-2012 period, other more important Eurozone countries with excessive levels of government debt like Italy, Spain, Portugal, and Ireland, also were struggling to recover from the 2007-2009 financial crisis. It was widely feared that if Greece defaulted and left the euro the financial markets then would target the debt of these larger countries for potential default. Since, at that time, much of this national debt was owned by the major European banks, it was feared that declines in the market values of this debt could bankrupt the major European banks and lead to a broader European economic disaster. Thus, European and IMF officials were willing to continue financing Greece in return for promised reforms not because they viewed Greece as important to the health of the broader European community, but rather to shield it from a default that might trigger this “contagion” to the larger, highly-indebted Eurozone members that would be harder to contain due to their size.
We have to admit to some ambivalence regarding the austerity program. As we repeatedly have discussed over the past seven years with regard to the US deleveraging, debt reduction programs inherently provide a brake on an economy and slow economic growth. In the US, we were able to restore growth during our deleveraging through Federal spending programs like TARP and massively stimulating monetary policies from the Fed. But, in a Keynesian sense, if GDP is the total of Household and Business Consumption, Government Spending, Investment, and Foreign Trade, and if Government Spending is being forced to shrink, the private sector will have to grow even faster if growth is to be achieved in the total economy. This school of economic thought argues that expanded Government spending is needed when contractionary forces are impeding an economy, and that austerity is an inappropriate policy at that time. Moreover, the ECB only recently adopted the kind of massively easy monetary policy that Greece has needed to produce private sector growth. Thus, we have some sympathy for the Greek grievances notwithstanding the reality that most of its economic problems are of its own making.
In January, Greek hostility to the austerity program manifested itself through the voting out of the prior New Democracy party and the election of a new government headed by the Syriza party, under the leadership of Alexis Tsipras, who quickly formed a left-leaning coalition government. Calculating that he could play on Europe’s fears of contagion and geo-political risks, he promised the Greek people that he would renegotiate the financing deals with the Eurozone nations, the ECB, and the IMF while he reversed or cancelled some of the previously promised reductions in government spending. For the past five months, he has acted as if he held a strong hand, demanding concessions from the countries and institutions to whom Greece is deeply in debt. He has traveled to Russia to meet with Putin to suggest that if Europe does not finance Greece and forces it out of the euro, then Greece might realign and obtain financing from Russia. He also has made overtures to the Chinese who might be anxious to expand their influence by providing financing to Greece.
To the surprise of the Greeks and many others, its creditors have remained strongly united in their opposition to a significant renegotiation of the 2012 deal. The German government’s left and right-wing factions have been in agreement, the French have strongly supported the German position, the IMF has not blinked, and the peripheral countries, perhaps enjoying the low interest rates that recent Eurozone policies have brought them as well as a resumption of economic and employment growth, have supported the Eurozone position. Consequently, Tsipras’ back was against the wall as Greece’s €1.6 billion repayment was about to come due on June 30. In a play for time, he called a national referendum on the austerity plan for Sunday, July 5th and urged his countrymen to vote against the Eurozone proposals.
The call for a referendum only antagonized Greece’s lenders more. For months, as Greeks pulled their money out of Greek banks and sent it to other European institutions, the ECB had kept the Greek banks afloat by providing them with billions of euros in emergency liquidity. But when the referendum was called, the ECB announced that it would make no further emergency liquidity transfers to the Greek banks until after the election. With depositors likely to want to pull their remaining deposits from the Greek banks and the banks lacking the euros to pay them, the Greek government was forced to shut the banks and impose currency controls. We think the ECB did this with the intention that letting the Greek citizens have a week without a functioning banking system and being unable to shift their money out of the country might encourage more of them to vote “Yes” on the referendum.
Despite the pressure, the Greek people voted against the creditor plan. While this “No” vote may keep this crisis inflamed a while longer and produce additional near-term weakness in stock markets around the world, we think the crisis’ market effects will be short-lived.
First, as we mentioned earlier, Greece is a small country whose economy is a relatively small part of the overall Eurozone. It is true that having Greece in the Eurozone has enabled the Germans and French to sell goods to Greece that Greeks could not otherwise afford were it not on the euro. Nonetheless, the Eurozone countries do not need Greece. Thus, if it should leave the euro, we do not think it would be damaging to the rest of the Eurozone.
Second, the situation is far different today than it was in 2010-2012. At that time, much of the Greek and peripheral Eurozone nations’ debt was owned by European banks. If Greece had defaulted on its debt and left the euro during those years, there was legitimate fear that the market then would target the other larger indebted Mediterranean countries and that the Greek crisis would be thus transmitted throughout this region. With the banks holding much of the debt of these countries, large declines in the market value of this debt had the potential to wipe out the capital of the major European banks. In this way, the small Greek illness was seen as having the potential through contagion to become a serious European disease. Also, at that time the ECB had not yet committed itself to providing whatever liquidity was needed to keep Europe’s financial system healthy and functioning.
Europe’s vulnerability at that time was reflected in US stock prices during the summers of 2010-2012. The S&P 500 fell by 16% during the first phase of the European debt crisis in 2010, then after recovering to new highs, it fell by almost 17% during the second European debt crisis of 2011, and then, after advancing to further new highs in early 2012, by almost 10% during the third phase of the crisis.
Since then, almost all of the Greek debt, and much of the peripheral countries’ debt, has been sold by the European banks so that they now have little exposure to weakness in the market values of this debt. In addition, the balance sheets of the European banks have been significantly strengthened over the past three years, giving them a greater ability to withstand capital losses. Finally, the ECB in January began a program of Quantitative Easing modeled on the program successfully executed by our Fed through which it is buying 60 billion euros of European government bonds each month. This has flooded the European banking system with liquidity and has produced the desired increase in the availability of bank credit.
Despite these positive developments, we remain alert to signs that this latest Greek crisis might be developing into something larger. When markets become nervous about potential defaults, these stresses quickly manifest themselves in widening interest rate spreads. A spread simply is the difference between two interest rates. If banks can normally borrow 3-month money at rates about 20 basis points (0.20%) above the rate paid by the government, then this “spread” is said to be 20 basis points. If markets become fearful of bank capital problems, they will demand a higher spread for taking this risk when they lend to the banks. Historically, the European banks rarely have had to pay a spread above 40 basis points for 3-month money. But, during the 2011 and 2012 debt crises, these spreads jumped as high as 100 basis points. Similarly, the European spreads for 2-year money that normally are below 50 basis points spiked to 120 basis points in 2011 and stayed high through the summer of 2012, signaling ongoing concern about contagion in the European financial system.
As the latest chapter of the Greek debt crisis has played out since January, we have been monitoring these debt spreads looking for evidence of contagion. There has been none. This week, following Greece’s default to the IMF and the No vote, the 3-month spread rose from 10 basis points to 11 basis points, well within its normal range below 40 basis points. Similarly, the 2-year spread remained at about 38 basis points, comfortably within its normal range below 50 basis points.
We also have been watching changes in the yields of Spain’s and Italy’s government bonds. The yields on these peripheral countries’ 10-year bonds rose as high as 6-8% during the 2011-2012 crises. This week they both are yielding about 2.35%. For comparison, US Treasury 10-year bond yields ended June at this same 2.35% rate. Thus, with Spain and Italy able to borrow money for ten years at the same cost as the US government, the markets do not seem nervous about this latest Greek crisis infecting these larger, more significant euro members with high levels of national debt.
Now that the referendum is over, it is likely to take months for Greece and its creditors to resolve this issue. In the meantime, we already are seeing positive results from the ECB’s new monetary policy. Eurozone money supply growth, a leading indicator of European business confidence, has picked up, hinting at an approaching acceleration in the pace of economic activity. Faster money supply growth also is an indication that European bank lending is increasing, another pre-condition to faster economic growth. Thus, we remain comfortable with our exposure to the European economy.
We also continue to think that there are at least two years left in the US bull market cycle. While the Fed is likely to begin raising its key Fed Funds rate in the months ahead, and the stock market may experience a modest 5-10% correction around that time as it has in the past, underlying US conditions remains quite favorable. The economy has plenty of liquidity, inflation remains below the Fed’s targeted level, and the Fed is likely to drain the excess liquidity slowly and cautiously. Since US recessions have occurred only after extended periods of illiquidity, we think a recession is unlikely within the next two years. In addition, with the period of US deleveraging nearly over and household borrowing again on the rise, and with employment and incomes rising, we expect US real growth to accelerate during the second half of this year. While corporate earnings have been somewhat depressed this year by the weakness in oil prices and the strength in the US dollar, we expect S&P 500 earnings to rise at about an 8-9% annual rate over the remaining years of this cycle.
Thus, we view the economic and earnings background for our stock market as likely to remain favorable through 2016. We also think that overall stock market valuations are reasonable, and, in contrast to some others, we think the S&P 500’s price-to-earnings ratio has the potential to rise further over the coming year. In conclusion, we view the latest Greek drama as a sideshow rather than the main event. We expect that Prime Minister Tsipras’ hubris, like that of some of the heroes of the ancient Greek tragedies, will prove to be his fatal flaw.