by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research
Key points
- The risk of a Greek exit has increased, although the timing is uncertain.
- In the meantime, we believe more market turmoil is likely, because most of the major tools to stem the crisis have political and legal barriers.
- We prefer underweighting Europe at this time because the potential for downside risks has increased and there is the likelihood of high levels of ongoing volatility.
In national parliamentary elections on May 6th, many Greeks swung their support away from mainstream parties and toward anti-austerity fringe parties, increasing the chance of an eventual Greek exit from the euro. This has led a lot of Schwab clients to ask some key questions—namely, if and when Greece could exit the euro, and what this would mean for investors. One word of caution before we start: It's unusually difficult to predict a resolution to this crisis, given the number of different scenarios and political decisions involved. Here are some of the questions we've heard most frequently:
- When would a potential Greek exit happen?
- If Greece is small, why would a Greek exit matter?
- What does Europe need to stem contagion?
- Could the ECB re-use prior tools?
- Will the Federal Reserve of the United States act?
- What are the arguments for keeping Greece in the euro?
- What are the implications for investors?
When would a potential Greek exit happen?
Because the May election didn't give any party the majority of the parliament, and a coalition government failed to emerge, Greeks go back to the polls on June 17. This election could create the conditions for a fast exit if austerity measures to be implemented by June 30 are outright rejected. While Greece's next quarterly bailout funding is due August 30, observers are concerned that Greece could run out of money as soon as July, as tax collection revenues are likely coming in below expected levels.
We believe an exit in the short-term is less likely because Europe doesn't yet appear to have mechanisms in place to deal with the aftereffects, or contagion. A Greek exit could begin to infect other countries, threatening their ability to issue debt at reasonable rates and potentially pushing them closer to an eventual exit from the eurozone, and spark a flight of capital from banks in other peripheral countries. Measures to stem contagion will likely need approval—either parliamentary or by the general public—before they can be enacted. Therefore, Europe is likely to again kick the can down the road and buy time, even if a coalition of hard anti-austerity parties forms a government in Greece.
We believe the probability of a Greek exit increases as the year progresses and over the next several years. Greece is likely to need continual relaxation of bailout targets, which will become increasingly unpalatable to the electorate in financially stronger countries.
If Greece is small, why would a Greek exit matter?
We believe that markets are focused on Greece primarily because of the risk of contagion to Spain and Italy. While even last fall there was hope that Greece's problems could be "ring-fenced," or contained, the risk of contagion has become increasingly apparent.
Italian and Spanish bonds move somewhat in tandem
Source: FactSet, iBoxx. As of May 29, 2012.
Spain's problems are complicating the situation. In Spain, the fiscal deficit has been revised negatively and the health of its banking system has been deteriorating. The Spanish fiscal deterioration, combined with the inaction of the European Central Bank (ECB) at its April monetary policy meeting, helped to increase yields on the government debt of an entirely different country—Italy. Italian and Spanish government bonds continue to move somewhat in tandem, even though you could argue that Italy's financial position is stronger than Spain's.
