Markets around the world continue to be volatile in response to concerns about the situation in Europe. As the value of “risky” assets has been falling in recent weeks, money continues to pour into the safety of the US dollar and US Treasuries. The US Dollar Index (ticker symbol DXY), which is a measure of the value of the dollar against a basket of six major currencies, is trading near a 20-month high. The yield on the 10-year Treasury note, which moves in the opposite direction as the bond’s price, is now close to a record low at 1.74%. Investors continue to display an insatiable appetite for an asset that will not yield enough to cover the expected rate of inflation, resulting in a loss of purchasing power. While this type of irrational investor behavior cannot go on forever, it does signal that investors are protecting against some very nasty tail risks. This European problem just won’t go away.
We read a research note by UBS economist Paul Donovan that argues quite convincingly that an orderly breakup of the European monetary union is not possible. “An orderly break-up is simply not an option, because to embark on an orderly break-up is to invite a disorderly break-up in anticipation of the end-game.” Essentially, Donovan is saying that markets do not stand idly by while politicians get their ducks in a row. Investors and other stakeholders move quickly to protect their interests, and this collective action (rational or otherwise) can move markets in dramatic fashion in a very short period of time. In the case of Greece and other struggling European economies, people are worried that a departure from the Euro will be accompanied by the reintroduction of the country’s previous currency. In Greece, the drachma would replace the Euro, and the drachma would rapidly weaken in value so that debts can be paid down more easily and so that companies and workers become more competitive in the global marketplace.
Obviously, nobody wants to be owed money by a country (or an entity or individual in that country) that may change currencies and pay their debts back in a new currency that is worth far less. So in anticipation of such a move, Donovan says that investors and other stakeholders will take swift and defensive action by doing the following: 1) the country’s trading partners will no longer accept that country’s counterparty credit risk, resulting in a dramatic decrease in international trade; 2) investors will no longer buy the country’s government bonds, resulting in an inability to fund the government; and 3) depositors will take their money out of the banks, resulting in a “run on the banks”. We have seen all these things happen, to a certain extent, in Greece as people speculate on a possible exit from the Euro.
But the worst-case scenario in Europe is not simply Greece leaving the Euro, but rather the contagion that may accompany such an outcome. This is why the rhetoric about Greece leaving the Euro is so destructive. If Greece is allowed to exit the Euro and replace its currency with a dramatically weaker drachma, speculation will immediately begin about who is next. Depositors, trade partners and investors will move rapidly to protect their interests without waiting to around to see what happens next. It is easy to see how the situation could spiral out of control.
We do not necessarily disagree with Donovan’s analysis. These are all valid points, and they represent at least some of the reason for all the volatility we are seeing in the capital markets. However, there are also many people who believe that a Greek exit from the Euro is a foregone conclusion at this point. These analysts believe that the ECB has been planning for this eventuality, and that the central bank will immediately institute measures to calm the markets and hopefully prevent the problems from spreading. Moreover, other problem European countries will take note of Greece’s pain and suffering as a result of its decision to exit, and they will do anything necessary to prevent it from happening to them.
We obviously have no idea how this is going to play out. However, it should be stressed that the Greek economy is a very small part of the world economy (0.3% according to Capital Economics), as well as a small part the overall European pie. If and when Greece leaves the monetary union, it is possible that the remaining parts of the pie will be stronger, not weaker. It is also possible that a definitive resolution to the Greek drama would be received positively, and not negatively, by the capital markets. Greece has been a news headline for about three years now. The constant attention on this small Mediterranean country over such a long period of time may increase the odds that the market has already discounted an unfavorable outcome for Greece.
Alternatively, we believe it is possible that the various European authorities will soon put a stop to the speculation about Greece exiting the Euro. This response could be triggered by increasing market volatility, the likes of which we are seeing again today. The policy response might entail a further Greek debt restructuring (more debt forgiveness), accompanied by some leniency with regard to previous austerity mandates. At the same time, Europe will have to show the markets that it will take more concrete steps toward a fiscal union.
So, in a nutshell, the uncertainty continues, and we all know that the markets do not like uncertainty. However, a Greek exit, followed by widespread and destabilizing contagion across the Eurozone, is but one of the many possible outcomes to this crisis. We do not think it is especially constructive to assume that the worst-case scenario will be the ultimate outcome. These problems were not created over night, and therefore the solutions will not come over night. The good news is that the US remains the best house on the Street. High-quality blue chip stocks appear increasingly attractive relative to the alternatives.