[dropcap]I[/dropcap]t’s tempting. But we don’t think so. Potential doomsday scenarios like the one we are in the midst of now occur frequently — we just remember them as less scary after the fact. The news is full of confident predictions about how this crisis will play out. Anyone who thinks they know the outcome proves only that they really do not know.
Most gains from holding equities are earned when fear of a scary situation proves excessive compared to reality. Reducing risk each time uncertainty spikes is a very costly strategy over time. Right now is a case where investors must bear increased uncertainty and risk to get the longer term superior returns of equities.
Stocks are down less 10 percent from recent highs, suggesting there is potential for significant further declines. However, the situation has been atop the headlines for a year now. Much of the downside should already be priced in. There is not the same surprise factor as the subprime crisis because the holders of Greek debt are fairly well known. Global stocks are attractively priced compared to earnings, which suggests there is also significant upside potential. Companies in the US, and even many in Europe, continue to post strong earnings. Bonds are not an attractive alternative.
An Update on the European Situation
Recent Greek elections cast serious doubt on the country’s ability, and desire, to meet austerity targets required to secure bailout money from the EU. Without this money, Greece would fail to make payments on obligations as soon as July, and would shortly thereafter be unable to pay civil servants. If so, the only way to try to maintain civil order would be to print a new currency to pay them. Most likely, in this scenario, the government would at some point mandate that banks pay out withdrawals in this new currency. Depositors would almost certainly lose significant buying power.
Therefore, it is entirely possible that a run on Greek banks begins soon. This could spark a run on banks in other weak countries like Portugal, Ireland and Spain. Absent severe government and central bank intervention, in this scenario the European financial system would grind to a halt. Economic losses would be severe.
The Realistic Analysis
There is no good way to predict bank runs. There are signs one has slowly started in Greece, but so far panic remains muted. It has reached the point, in our opinion, where a rational person in Greece should withdraw their Euros from a Greek bank. But many people in Greece are not rational and/or have little understanding of the situation, so there may be no bank run.
- If there are no bank runs, we will see in June whether the Greek people elect leaders partial to meeting austerity measures and staying in the Euro, or ones who are more likely to guide the country out of the Euro. If it is the former, we should have another period of relative calm. Unfortunately, it is hard to imagine Greece being able to support itself in the Euro indefinitely, so the problem would likely resurface at some point in the future.
- If there is a bank run in Greece, the ECB could strongly guarantee Euro bank deposits in other countries and perhaps in Greece as well. This should be sufficient to stop bank runs elsewhere. Unfortunately, the ECB does not specifically have authority to do this. Nevertheless, it would probably be allowed to proceed anyway as the alternative could be continent wide disaster.
If Greece exits from the Euro sometime in the next year, but the ECB is able to maintain a firewall around other countries (a highly likely outcome), the results would be bad, but not disastrous (for those outside of Greece).
How bad? Greece is 2 percent of Europe’s GDP. Europe and global stock markets could absorb this loss easily. However, the broader freak-out factor and resulting liquidity freeze is impossible to predict. As with Lehman a few years back, much of the outcome will be determined by how governments and central banks react. Europe may have more difficulty reacting swiftly because there is no single authority. At the end of the day Henry Paulson (with consent of George Bush) and Ben Bernanke were acting without oversight or rules– which strangely enough turned out to be a good thing.
Currently, the stock market trades down whenever the probability of a Greek exit increases. But this would likely change quickly if visibility of a separation that doesn’t roil Spanish, Portuguese and Italian banks and bond markets emerges.
One positive – this situation has been brewing for a long time. Governments, countries and individuals have had time to prepare. Our best guess is the banking system outside of Greece will remain open, the ECB will flood the system with liquidity and Europe’s recession will deepen, but we will not have a repeat of what happened in 2008-2009. In the end, a stronger (though likely smaller) European Monetary Union with a more enabled central bank may emerge.
Volatility (up and down) will likely increase in the coming weeks. It will be an interesting year.