Policy, Foreign Emerging

Positioning Around a Greek Shutdown

May 22nd, 2012 | By Nick Sargen


  • Following four months of relative calm, markets have turned turbulent again amid growing worries that Greece could exit the euro-zone. Adding to investor concerns are developments in Spain, where the authorities recently made a sizable infusion of capital into one of Spain’s largest banks, and a series of downgrades of Spanish banks by Moody’s is anticipated.
  • These developments have triggered a flight to quality. Yields on German Bunds, U.K. gilts and U.S. treasuries have fallen to record lows, while sovereign credit spreads for countries in the periphery of the euro-zone have widened and equity markets have sold off.
  • We have responded to these and other developments by reducing the target High Yield allocation in our client portfolios to 35% of the maximum allocation from 75% previously. While we remain comfortable about the long-term prospects for this asset class, the most recent change reflects a tactical reduction in the amount of risk for this sector.

Greek Elections Set the Stage for a Showdown

The catalyst for the latest market turmoil was the Greek election results on May 6, in which the two largest political parties lost ground to the leftist SYRIZA party, which campaigned on renegotiating the terms of the Greek bailout that was reached with the troika (EC, ECB, and IMF) in November. The inability to form a new coalition government has set the stage for a new election on June 17, where the latest polls show the SYRIZA party to be tied for the lead.

Should the head of the SYRIZA party, Alexis Tsipras, becomes Greece’s Prime Minister, the stage would be set for a showdown with the European Union. If Greece declares a moratorium on its debt payments, for example, it could begin a process that ultimately leads to its loss of access to the regional payments and settlements system of the euro area and thereby force a Greek exit from the monetary union. There is, of course, a possibility that a more euro friendly government prevails or that the Troika is willing to make concessions to keep Greece in the euro-zone. However, we would assess the possibility of an eventual Greek exit to be on the order of 50%.

Amid these developments, I have read several reports about the consequences of a Greek exit. One by JPMorgan’s economists (Global Data Watch, May 18, 2012) offers the following assessment:

“A Greek exit from EMU would produce significant contagion to other peripheral countries, where both sovereigns and banks would come under pressure. Limiting the damage of contagion would depend crucially on the speed and magnitude of the policy response…First, the banking system would need to be shored up with shared resources provided with area wide deposit guarantees to limit capital flight and bank recapitalizations. Second, as Spain’s and Italy’s access to capital markets becomes impaired, the ECB would likely need to restart its SMP program and the EFSF/ESM firewall for sovereigns might need to be drawn upon. Finally, a further injection of liquidity and new monetary stimulus would be needed to bolster confidence and offset the tightening of credit market conditions. In each of these areas the ECB holds the key to success. It is the only institution in position to act quickly and with the capacity to provide immediate resources to support both banks and sovereigns.”

Spain in the Spotlight

The country that appears most vulnerable is Spain, where there is increased concern about the health of the banking system. The Spanish Minister of Finance reportedly gave the Financial Times (May 19, 2012) the following assessment:

“The battle for the euro is going to be waged in Spain…It is a large economy with an orthodox government implementing orthodox policies.”

Spain’s central bank recently disclosed that the value of bad loans held by the country’s banks increased by over a third the past year to nearly euro 150 billion. Loans in arrears accounted for 8.4% of the total outstanding in March, the highest since the property market began to collapse. Concerns over Spanish banks heightened after the government was forced to inject capital into Bankia, a conglomerate created in late 2010 out of several smaller savings banks that were bankrupted by bad real estate loans.

In the wake of these developments, the deposits of Spanish banks are now being monitored closely by officials and the public. The latest data showed a slight increase in total deposits through the end of March, but a fairly steady exodus of deposits by foreigners. By comparison, deposit flight from Greek banks has intensified lately, and total Greek bank deposits now are approaching euro 60 billion, or more than a third below the level in 2009.

Compared to Greece, Spain’s economy is much larger – the fourth biggest economy in the euro-zone – and its banks are much more integrated within Europe and other parts of the world, especially Latin America. Therefore, it is imperative that European authorities have a contingency plan in place to deal with the fallout from a possible Greek exit.

Investment Implications

Given the heightened uncertainties surrounding Europe, as well as the prospect of a highly contentious election in the United States, we have been reviewing our portfolios to reduce risk elements in them. At our most recent Fixed Income tactical asset allocation meeting, we reduced the target High Yield allocation in our client portfolios to 35% of maximum allocation from the previous target of 75% of the maximum. While we remain comfortable with the long-term prospects of the asset class and will maintain exposure in portfolios, this most recent change represents a tactical reduction in the amount of risk from this sector. In our opinion, the near-term risk/return tradeoff has worsened in light of the ongoing difficulties in Europe, uncertainty about the strength of the US economy and response from the Fed, the upcoming US presidential elections, and the looming “fiscal cliff” at the end of 2012.

High Yield has proven to be very resilient thus far in the face of these risks, returning over 6.5% year-to-date, and with risk premiums near the long-term average. Investors’ flows into High Yield have been exceptionally strong as investors search for additional yield in the current environment. We feel reducing the risk from this asset class is prudent given the risks we have highlighted. This tactical change is very similar to one we executed in the spring of 2011, where we reduced our allocation to High Yield essentially for the same reason, excellent performance in the face of growing risks. Risk premiums widened in the summer/fall and we were able to add back to High Yield at wider risk premiums.

In the short-run, the proceeds from this reduction will be invested in US Treasuries. We are not making a long-term statement that the US Treasury market offers value at near historic lows in many maturities; instead it offers a liquid alternative while we wait for other opportunities to move back into other areas of the fixed income market or back into High Yield.