What if Greece exits the euro zone

(Reuters)

By Hartmut Issel JUNE 5, 2012

While the idea of a Greek exit from the euro zone has long been rejected by politicians and deemed nothing more than a “tail risk” by most investors, there has been a clear shift in opinion after the Greek election in early May failed to form a new government. The repeat election on June 17 is therefore critical to the country’s future in the euro zone and to financial markets worldwide.

If Greece fails to form a new government, or forms one that rejects its bailout plan with official creditors, the probability of an exit would rise significantly.

Aside from the election, bank runs could speed up Greece’s departure from the currency union. Greek banks are technically insolvent, as they have not been recapitalised since taking losses when the government restructured its debt last March. The 50 billion euros planned for their recapitalisation has not been released by the creditors — the IMF and European Union — and is, in fact, part of the same bailout plan that is on the line in the upcoming election.

Our baseline scenario is that Greece will not exit the euro zone within the next six months — we put this probability at 20 percent — as we believe both the Greek electorate and the creditors understand that the stakes of an immediate exit are too high. Still, investors have been asking how they should be positioned in case this 20-percent probability does occur. The key worry is contagion and the consequences of the Greek exit spilling over to other countries such as Portugal, Ireland, Italy and Spain.

WHERE TO PUT YOUR MONEY

In a nutshell, it is important to distinguish the two phases that could follow a Greek exit: first, bank runs and widening government bond spreads in other peripheral countries; and second, potential countermeasures by the European Central Bank (ECB), which is likely to respond faster than the individual central banks.

In phase one, the U.S. dollar would be the key outperformer across currencies, including Asian ones. The euro would likely weaken by up to 10 percent from an initial reaction, though the euro may temporarily recover depending on subsequent policy actions. Investors therefore need to take currency risk into account when making investment decisions.

U.S. Treasuries, German Bunds, UK gilts and sovereign bonds of stronger countries would serve as safe havens. Bonds of multinational corporations and non-cyclical-sector companies should also be preferred; while they may have difficulty generating absolute positive return, they should outperform bonds of financial institutions and cyclical issuers.

European equities would be the main underperformer — possibly dropping 15 pct — but emerging markets, including Asia, are also likely to suffer in a sell-off. In a global portfolio, U.S. equities are preferred, and stocks of defensive sectors, such as consumer staples and healthcare, could help stabilise portfolios. Overall, in an immediate exit scenario, equities should be underweighted.

Commodities will not offer much comfort: they could pull back by about 20 pct given that China and Europe, its biggest export market, account for 60 pct of global demand for base metals and 30 pct for oil. Gold may also be sold down as investors scramble for liquidity.

In phase two, one key thing that will change is that a large liquidity easing by the ECB, such as a repeat of its long-term refinancing operation (LTRO), would benefit gold. As we expect a Greek exit to lead to extreme economic and financial stress, other central banks, such as the Federal Reserve, the Bank of England, and the Bank of Japan, would provide further monetary stimulus measures. In past episodes of such “quantitative easing,” gold gained investors’ trust.

In a risk case, portfolio diversification remains a key preemptive, risk-mitigation strategy, even though risky assets tend to behave in the same way during times of financial market stress. Cash may be one of the few asset classes that will enable investors to preserve capital during such times — but only temporarily. With inflation rates higher than cash interest rates in most major markets, cash would not achieve real capital preservation.