In Greece, one crisis, two possible outcomes
July 10, 2015
As investors and financial analysts contemplate the possibility of a Greek exit from the European Monetary Union, we examine two possible scenarios that might unfold: (1) our base-case scenario, in which Greece remains in the euro zone (and which we think has the highest probability of playing out), and (2) our stress-case scenario, in which Greece leaves the euro zone (and which we believe has a low probability of happening).
Note that the risks are strikingly similar under both scenarios.
- A compromise is reached in which Greece agrees to refined provisions under the current bailout program. This allows the remaining bailout funds to be released.
- A third bailout of approximately €50 billion will be needed for the next three years to cover the redemption of bonds and other financial obligations.
- Greece receives meaningful concessions, piquing the interests of other peripheral countries that have faithfully adhered to bailout terms. This stokes the potential for populist parties to gain traction and attempt to repeal the austerity measures they are currently contending with.
- Neither side concedes and an agreement is not reached, ultimately leading to a default on sovereign debt.
- Greece leaves the monetary union. Suddenly finding itself without a currency, it has no choice but to reinstate the drachma. The currency would weaken almost instantly, putting debtors under stress as they attempt to repay loans denominated in euros.
- The Greek economy plunges further into distress as benefits afforded to them under the euro are no longer accessible.
- If Greece were to quickly rebound, its resilience would provide an alluring example for other countries who are deliberating the possibility of leaving the union. Already, grassroots efforts in other European countries are gaining notoriety, with the Spanish Podemos coalition a notable example.
- A precedent is set: It is not completely reckless to challenge the monetary union.
No path for smooth sailing
Given the unique circumstances that are in place, and the high level of uncertainty that accompanies them, a risk-free path is very unlikely to appear under any scenario. Consider:
- In the realm of sovereign bonds, short-term spread volatility should be on order, as yields of peripheral countries (such as Italy, Portugal, and Spain) increase on fears of contagion. We note that in reality, the risk of contagion will be somewhat limited, given the material reduction in Greek exposure by the banking and private sectors.
- In the longer term, additional countries could be motivated to pursue an exit from the currency bloc, boosting volatility down the road and setting off a flight to safety within financial markets. (Across the portfolios we manage, the exposure is mainly to high-quality multinational credits that, in our view, should be able to weather this scenario.)
Rationale for sidestepping Greek holdings
Within the portfolios we oversee, we don’t own any positions that harbor risks related to Greek debt. Part of the rationale for avoiding Greek holdings is our belief that if Greece defaults on a debt obligation, the risk of contagion will be difficult to quantify.
We believe market volatility will be propagated by the Greek debt crisis for some time to come. Speaking of volatility: As risk managers, our plates are becoming increasingly full as we also monitor events outside Europe. This includes equity swings in China, where the Shanghai Stock Exchange Composite Index dropped 18.8% between June 12 and June 26, slow economic growth in the United States, and, of course, the potential for monetary tightening by the Federal Reserve in the second half of 2015 (source: Bloomberg).
Hear more from our investment teams on recent market volatility
The views expressed represent the Manager's assessment of the market environment as of July 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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