Three Things To Buy After Greece Restructures Or Defaults On Its Debt

JUN 4, 2015 @ 7:51 PM 9,191 VIEWS

Forbes

By Henry To, contributor

 In two recent articles published earlier this year (“Chances of Greek Euro Exit Have Not Diminished” and “What To Buy if Greece Exits the Euro Zone”), I discussed:

1) Why the Greek economy—given its huge debt load (at 317% of GDP), its vast economic differences with its fellow euro zone member countries, as well as Germany’s refusal to directly subsidize its spending—cannot operate efficiently or grow as a member of the European Monetary Union (EMU). As such, Greece is better off in the long-run by exiting the EMU;

2) Why a Greek debt restructuring or default on its two bailout packages totaling 240 billion euros is inevitable sometime this summer. When my most recent article on Greece was published two months ago, Greek bank deposits had fallen to a ten-year low of 140 billion euros, as both Greek corporations and citizens lost confidence in their own banking system and chose to transfer their savings into offshore bank accounts. Beginning in March, there were also increasing reports of the Greek government running short of funds to maintain their payments to the “Troika” (collectively the European Commission, the International Monetary Fund, and the European Central Bank), while struggling to pay their own pensioners (the Greek government had ceased paying their suppliers and vendors already);

3) Three investments to make in the event of a Greek default or exit from the EMU. Specifically, I mentioned the Euro, i.e. the FXE ETF, could be a good, short-term buy should a Greek default or exit put more downward pressure on the euro, given the currency’s already oversold condition versus the U.S. dollar (my buy target for the euro is a one-to-one exchange rate with the U.S. dollar).

I also mentioned that Greek stocks (GREK) are now very cheap; moreover, Greek stocks should act as a “safe haven” for Greek citizens if the country exits the euro and devalues its currency, especially since the Greek government is likely to implement capital controls to prevent capital from leaving the country. The third investment is long-dated U.S. Treasuries (TLT) as this asset class is still cheap relative to Euro Zone government bonds. E.g. the difference between U.S. and German long-dated government yields was close to a 30-year high, and remains so today. U.S. Treasuries should also act as a safe haven should Greece default or exit the EMU.

Since our articles were published earlier this year, I believe the chance of a Greek default or exit from the EMU has continued to rise. Capital has continued to leave the Greek banking system. Officially, Greek private sector deposits are down by over 100 billion euros from its 2009 peak. As of the end of April 2015, Greek private sector deposits sat at just 133.7 billion euros. I believe Greek private sector deposits declined by another 3 billion euros during May, as the European Central Bank (ECB) increased its Emergency Liquidity Assistance (ELA) limit by about that amount in May (the change in the ECB’s ELA limit has tracked the amount of Greek capital flight since the beginning of this year). I thus estimate that Greek private sector deposits now total only 130 billion euros or even less as of today.

In my opinion, Greece has already run out of time to strike a deal with the Troika to prevent a broader restructuring or default. The first “test” will be tomorrow when a 297.9 million euro to the International Monetary Fund (IMF) is due. Recent statements, as well as Greece’s need to tap into an emergency IMF account earlier this month (which needs to be repaid) to make a 750 million euro payment to the IMF, suggest that Greece could miss its first IMF payment as soon as tomorrow. Assuming Greece makes its payment tomorrow, its next text will be on June 12, when it is scheduled to make a 335.2 million euro payment to the IMF.

A missed IMF payment would not immediately trigger a Greek default, as Greece would receive a two-month “grace period” to make its payments after which the IMF would begin to limit Greece’s use of its general resources. For Greece, however, a missed IMF payment is very serious as the IMF will subsequently freeze all its resources to the country, including half of the 7.2 billion euro in assistance that has been promised if Greece is able to strike a compromise with the Troika. In other words, a missed IMF payment makes it much harder to unlock further aid to Greece.

Even if Greece is able to compromise and make both of its June 5 and June 12 payments, the country still faces many—I would argue, insurmountable—obstacles. First, it still faces nearly 1 billion euros in IMF repayments due in mid-June, as well as 6.8 billion euros in repayments to the ECB in July and August. That means even if Greece is able to unlock the 7.2 billion euros in remaining aid, all of it would go towards making debt repayments back to the IMF and the ECB, with the last repayment scheduled for August 20.

Greece would thus need to have a third bailout package lined up by no later than August 20 in order to avoid a debt restructuring or default event. Consensus earlier this year suggests an additional 30-50 billion euro bailout package is needed; I believe this is no longer sufficient since the Greek economy recently fell back into a recession. There is currently no political will within the Euro Zone to strike a deal to prevent a Greek default, let alone the will to put together a third bailout package (likely in the 60 to 80 billion euro range) for Greece.

As such, I believe a Greek restructuring or default is a certainty, with a possible exit from the euro zone later this year. Aside from the three investment opportunities that I discussed above and in my earlier article, I am evaluating three additional investment opportunities in order to prepare for a Greek default:

1) A Potential Buying Opportunity in Gold (GLD)

A Greek default or exit from the EMU will be accompanied by Greek capital controls, and ultimately a devaluation and a return back to the Greek currency, the drachma. Such a scenario will likely encourage capital flight from the euro zone’s peripheral countries, such as Portugal and Spain, as investors begin anticipating a further fragmentation of the euro zone. Recent local elections in Spain saw the surge of significant left-wing, anti-austerity support, with Spanish voters leaving the ruling right-wing Popular Party, and shifting support to a new radical-left part, Podemos. Going forward, I anticipate a surge in both anti-austerity and anti-euro sentiment in countries such as Portugal and Spain. At the very least, the ECB will need to continue to ease monetary policy or engage in more asset purchases to keep the EMU together. This means gold will act as a safe haven for most euro zone citizens who want to protect themselves against a further decline in the euro or ultimately, a fragmentation of the entire EMU.

For other reasons that I described in a recent article (“Three Gold Miners to Buy When Gold Bottoms Later This Year”), I thus believe gold is approaching the end of its bear market. Any purchases here could be made either through the SPDR Gold Trust, the GLD ETF (exchange-traded fund), or physical gold.

2) European Financials (EUFN) Could Offer a Good Long-Term Buying Opportunity

EUFN is an ETF that tracks the MSCI European Financials Index, an index consisting of equities in the Developed Markets in the European financial sector. Its top five largest holdings are: HSBC Holdings (9.0% of assets), Banco Santander (5.3%), UBS Group (4.0%), Lloyds Banking Group (3.8%), and Allianz SE (3.6%). While none of EUFN’s top ten components have significant exposure to Greece, I believe a Greek default will likely trigger a sell-off in European financial stocks as investors discount the possibility of contagion effects or a further fragmentation of the euro zone. A general sell-off in European banking stocks would provide a good buying opportunity, however, assuming European policymakers, including the ECB, does everything in its power to keep the EMU together after a Greek default or exit from the euro. Moreover, the European banking sector, including that of the UK, have raised significant capital and cleaned up its balance sheet in the aftermath of the 2008-09 global financial crisis.

3) International Government Inflation-Protected Bonds (WIP) May Provide a Good Tactical Buying Opportunity

The WIP ETF purchases international government inflation-protected bonds, mainly focused in Europe (UK, France, Italy and Germany) but which also include countries such as Canada, Australia, and Chile. In the event of a Greek default or exit from the euro, it is likely that interest rates will rise in France and Italy, as investors begin anticipating a fragmentation of the euro zone. The WIP ETF has three main sources of returns and risks: 1) interest rates–bond prices generally move inversely to interest rates, 2) currency—since WIP’s portfolio consists of government inflation-protected bonds issued by foreign governments, WIP’s performance will suffer if the U.S. dollar continues to strengthen, and 3) inflation of the issuing countries, such as UK inflation, French inflation, and Italian inflation. The higher the inflation rates of these countries, the higher the return for WIP.

If investors begin anticipating a further fragmentation in the euro zone, it could be a “perfect storm” for European government inflation-protected bonds, and for WIP, as interest rates for Italy and even France could rise as investors repatriate capital from the euro zone’s peripheral countries. At the same time, deflationary pressures could set in as these countries would need to bear some of the burden of a Greek default or restructuring. On a larger scale, the euro will likely decline as well, as the Euro Zone’s economy will likely slow down again given the significant political uncertainty. Such a perfect storm could create a short-term buying opportunity for WIP, as I do not believe the Euro Zone will be broken up, even if Greece exits. In this scenario, I also believe the ECB will expand its asset purchase program which will help keep the euro zone together and offset any deflationary pressures as a result of a Greek default or restructuring.

Disclosures: My firm, CB Capital Partners, or I may have material financial interests in FXE, GREK, TLT, GLD, EUFN, or WIP and may hold, sell, or trade them depending on market conditions or when fundamentals change.