The Grecian Fallout
Earlier this week, Standard and Poorâ€™s downgraded Greeceâ€™s credit rating three notches to CCC, giving the beleaguered country the worldâ€™s worst debt grade according to S&P. This intensified fears that the country will default on its debt. Just last week, when President Obama urged other European nations to help Greece prevent default, he also pledged US help in resolving the matter, although provided few if any details. Given our own deficit struggles, this was an eye opening offer, and perhaps an indication that the administration is fearful of the fallout from a Greek default. It also brought the Greek debt crisis back into media focus, a focus that had been somewhat lost amid the swirl of other world events. These included the tsunami in Japan and its subsequent nuclear disaster, and more recently, the events in Libya and severe weather and intense flooding experienced in some parts of the US.
Indeed, the world has seemingly been plagued by one crisis after another, and it seems to have become more intense in the past several years. Somehow each crisis is new and different; each raises investorâ€™s fear level to one extent or the other. â€œItâ€™s different this timeâ€ is the often-uttered phrase as the next sudden unforeseen event grips our minds and the markets. Yet crises are nothing new. Weâ€™ve faced them often in our history, but with each passing year, the coverage of these events grows by leaps and bounds as every 24 hour news outlet, website, or blogger peppers a news-hungry populace with information.
The plight of Greece, which in 2010 had the worldâ€™s 32nd largest economy in terms of GDP, is a case study in what can happen when a nation allows spending to get out of control, and lacks the ability, or the will, to adopt meaningful measures to cut expenditures. But it is not yet a case study that can be written. The ultimate outcome is still in question, the situation has gotten worse, and it is one that investors need to be aware of.
Suffice it to say, the other members of the European Union are deeply regretting Greeceâ€™s entrance into the EU in 2001. The 12th member admitted, Greece was technically ineligible to join. The country never actually met EU requirements that budget deficits not exceed 3% of GDP, a fact that did not come to light until 2004, when the country made the admission. Despite owning up, Greece was allowed to remain in the EU, perhaps aided by the fact that other members such as France and Germany had also at times exceeded the 3% limit.
Moodyâ€™s three-notch downgrade of Greeceâ€™s credit rating to Caa1 on June 1st was yet another leg down in what appears to be a death spiral for the countryâ€™s credit. That rating puts Greece well into junk status, by a full seven notches. The ensuing fear that Greece will have to restructure its debt has continued to damage the Euro.
The problem for the EU is that their currency is deeply affected by the weakest members. Had Greece not been a member of the EU, and maintained its own currency, the country would arguably still be in crisis, but the potential extent of the damage would be more contained. All EU members are inexorably connected by a single currency, and the stronger members will suffer as a result of malaise by the weaker. Unfortunately, Greece appears to be the tip of the iceberg, as other members such as Portugal and Ireland are also facing economic crises, although none appear more dire than that of Greece.
Greeceâ€™s attempts at austerity measures in order to reign in their ever burgeoning debt date back to early 2005, following the New Democracy partyâ€™s seizure of power from the socialists 21-year reign. Among other things, the country ran up massive amounts of debt following itâ€™s hosting of the 2004 Summer Olympics, and was facing pressure to put its financial house in order. Measures taken included tax hikes on tobacco and alcohol, an increase in the Value Added Tax (VAT) and a crackdown on tax evasion. The country appeared to have been on the right track in 2006, after reporting GDP growth of 4.1% for the first quarter of the year. But the true state of the Greek economy began to show through, and in 2009, after George Papandreouâ€™s Panhellenic Socialist Movement won power, deficits were projected at more than 12% of GDP.
That December, ratings agency Fitch downgraded Greeceâ€™s long term debt from A- to BBB+, and Papandreou subsequently unveiled an austerity plan that included cutting â€œred tapeâ€ and government jobs through attrition in order to cut the deficit to 3% of GDP by 2013. This initial salvo was met with a groan from other members of the EU because it did not go nearly as far as other struggling nations such as Ireland had with its own austerity plan. Likewise, it was also met by strong resistance from Greek workers, who promptly went on strike to protest cut backs. The specter of further social unrest preventing Greece from bringing about meaningful reform ultimately resulted in Standard and Poorâ€™s also cutting Greeceâ€™s rating, from A- to BBB+ the same week.
As bond spreads between Greek debt and other EU members widened, signaling a lack of confidence in Greeceâ€™s ability to address the crisis, workers continued to take to the streets, and the government continued to strengthen austerity measures, putting the Greek government between a rock (those calling for stronger measures) and a hard place (the protesting unions and pensioners). Equity markets took notice on April 27, 2010, when Standard and Poorâ€™s downgraded Greek debt to junk status, and yields on Greek debt skyrocketed. World markets reacted negatively, and the S&P 500 fell 2.4% on the same day. By May, amid talks of a 110 billion Euro bailout, whose strings included Greece agreeing to wage freezes and pension cuts, protests intensified, as did fears that such a bailout would not prove successful. Equity markets reacted strongly around the world again, with the S&P falling 2.4% on May 3rd. Later that month, with the bailout approved, Greece began receiving loans from both the IMF and EU, and continued down the austerity road, among other things, raising the retirement age for women from 60 to 65 (same as men) in July. The following month, the IMF claimed that Greece was making progress, and was ahead of schedule, and distributed additional loan money to the country.
But by January of this year, Fitch also cut Greek debt to junk bond status, and the following month although the EU and IMF approved another 15 billion Euros of bailout money, they were still skeptical of the pace and scope of Greeceâ€™s austerity and privatization efforts. That skepticism was warranted, as Greece reported a 2010 budget deficit of more than 10% in early April. In May, S&P cut Greeceâ€™s credit rating to B, and once again it appeared as though the wheels were coming off.
Moodyâ€™s recent downgrade, which implied that the rating agency believes thereâ€™s a 50% chance that Greece will default within five years, heightened fears, and in the past week thereâ€™s been a scramble to provide additional help, including the aforementioned comments by the president. Germany has suggested that private banks allow Greece to extend debt maturities by seven years, an idea that essentially forces private investors to participate in a second bailout, and has been met with resistance.
Clearly, the situation in Greece is an example of too much, too little, too late. The country was too slow to adopt meaningful austerity measures, with at least a portion of its populace outraged at any cuts, unwilling to give any ground, and equally oblivious to the severity of the situation. The 110 billion euro bailout package has not solved Greeceâ€™s problems, nor have the countryâ€™s austerity and privatization efforts.
With billions in debt coming due in subsequent years, it appears as though additional bailouts would be necessary, but may not be effective. Ultimately, Greeceâ€™s fiscal woes run deep, and may not be fixable. The nation may lack the appetite for the level of austerity necessary to right the ship. That being said, the prospects of default at some point are very real, and this scenario is already somewhat priced in, as Greek ten year bond yields are currently in excess of 17%.
The question for investors is the severity of fallout from a Greek default, which would be the first ever in the euro zone. Thereâ€™s little doubt that it would send shock waves around Europe, perhaps carry over to some of the other weaker members of the EU such as Portugal and Ireland, and our own equity markets would also react negatively, at a very fragile time. However, the argument could be made that a Greek default is already, at least partially priced in. Once the initial â€œshockâ€, perhaps too strong a term given what we already know of the severity, wore off, our markets would recover. Some of the biggest international crises weâ€™ve faced, including the Russian financial crisis in 1998, and Asian financial crisis in 1997 resulted in much quicker than expected recoveries. Admittedly, this is new territory; a situation that affects the entire EU, a group of countries that are tied together for better or for worse.
Of course the prospect of further bailouts for Greece, which has nearly $500 billion of debt, might be even less appealing than default. Throwing good money after bad may only serve to kick the can down the road, and inflict further damage. Ultimately, this may be a case of taking some pain now, or taking more pain in the future.
Recognizing the aforementioned risks and corresponding uncertain outcomes, we have taken steps to help reduce portfolio volatility and temper downside risk. In fixed income portfolios, particularly internationally, we have reduced allocations to passive strategies in favor of more aggressive active management. Exposure to equity investments is carefully tailored to each clientâ€™s risk tolerance and the balance between domestic and international stocks is continuously monitored by our investment team and investment committee. We deploy global macro managers to continuously assess global conditions in an effort to take advantage of opportunities while avoiding situations where the reward for risk taken is not in our favor. Lastly, a number of hedged equity and credit strategies are at our disposal and deployed as appropriate for our clients.
While it is not practical or possible to side-step all market risks, the strategies used in our client portfolios are leading edge and reflective of the current environment. They are continuously monitored by our team and executed by some of the most highly regarded investment managers and firms available.
As usual, my team and I are only a phone call away should you wish to discuss these or other financial planning and investment matters.
This market commentary is an advertisement and was written and produced by Michael W. Conway of Summit Financial Resources, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel: 973-285-3600, Fax: 973-285- 3666 with assistance from John Heller, CFA . Sources of performance and economic statistics: MorningstarÂ® and Bloomberg. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poorâ€™s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The MSCI Developed Markets and Emerging Markets Indexes were created by Morgan Stanley Capital International (MSCI) and designed to measure equity market performance in global developed and emerging markets, respectively. The Barclays Aggregate Bond Index is a market capitalization-weighted index comprised of government securities, mortgage-backed securities, asset-backed securities, corporate securities, and a small number of foreign bonds traded in the U.S. It is used to represent the universe of bonds in the domestic market. REITs, Real Estate Investment Trusts, are securities that invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding markets or other financial information, are obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.