What If Greece Defaults?
By RANDALL W. FORSYTH
June 27, 2015 12:11 a.m. ET
The saga of the Greek debt crisis seems almost as long, with nearly as many twists and turns, as that of Odysseus. And like those of us who had to plod our way through Homer’s epic in school so many years ago, the financial markets cannot seem to avoid Greece and its ongoing struggle to remain in the euro zone, while it copes with an outright economic depression.
At the beginning of last week, there was short-lived optimism that the Greek government was at least talking to its key creditors: the International Monetary Fund, the European Commission, and the European Central Bank. But by week’s end, the negotiations had broken down. German Chancellor Angela Merkel said that she and French President François Hollande had urged Greek Prime Minister Alexis Tsipras to accept an “extraordinarily generous” offer from the creditors. Tsipras’ reaction: Greece wouldn’t give in to “blackmail and ultimatums.”
With a crucial meeting set for Saturday to stave off default on a key June 30 payment due the IMF, the consensus seemed to be that yet another 11th hour and 59th minute deal would emerge. Indeed, Greece’s inflexible stance has led many to believe it’s a negotiating tactic conceived by its finance minister, Yanis Varoufakis, an economist who specializes in game theory, to wring the best deal from its creditors. And to add to the uncertainty, at week’s end Tsipras called on Greek voters to vote on July 5 on whether to accede to further austerity demands by international creditors.
These developments raise a crucial question: What if Greek officials aren’t bluffing and are preparing for a default? That could lead to capital controls, the shuttering of banks, and even an exit from the euro zone, and, in turn, a global financial crisis the likes of which hasn’t been seen since the failure of Lehman Brothers in September 2008.
As Rahm Emanuel commented when he was White House chief of staff early in the Obama administration, never let a good crisis go to waste.
Greece’s Treasury could scrape together its remaining euros to buy put options on global bourses to cash in on the crisis, and then use the profits to pay down a portion of its crushing debt, now equal to 175% of gross domestic product.
It’s not as if previous Greek governments have been averse to utilizing financial derivatives to bolster their fiscal position. With the assistance of Goldman Sachs (ticker: GS), Greece entered into complex currency swaps early in the past decade to disguise its borrowing, in order to be admitted to the euro zone.
Even though it would be cheap to bet on a market decline, given the depressed level of options premiums, it’s unlikely that Athens would take this Swift action to adopt Barron’s modest proposal to raise some quick cash and pay down some debt.
But other governments have purposely utilized the equity markets as a policy tool. The Federal Reserve partially explained its past pumping of money into the financial system through massive purchases of securities as a means to lift the prices of assets, notably stocks, and, in turn, bolster investment and spending. The central bank has succeeded in its first aim, with major U.S. equity indexes near records.
In Japan, monetary expansion is a cornerstone of Abenomics, and with it, the lifting of stock prices, which still remain at just above half of their 1989 bubble peak. In China, the stunning ascent in stocks since late last year not only has drawn in millions of individuals, but also has provided a means for overly leveraged state-owned enterprises to bolster their balance sheets and replace debt with equity.
To be sure, the markets expect a benign outcome in this turn of the Greek odyssey. The Athens bourse actually rallied 16% last week, including a 2% pop on Friday, ahead of the outcome of the weekend’s negotiations. The yield on Greek two-year bonds, a key barometer of confidence in the nation’s finances, fell sharply, albeit to a crisis-level 21% from 30%.
In its midyear investment outlook, Barclays Capital suggested that a Greece-induced selloff would be a signal to buy the proverbial dip, especially in European equities. Any market mayhem would be met with an aggressive ECB response, in keeping with the pledge of nearly three years ago from the bank’s president, Mario Draghi, to do “whatever it takes” to preserve the euro, according to Barclays and a wide array of other market observers.
But a steep slide in China’s market isn’t an automatic buying opportunity, Barclays contends. With a 7.4% drop on Friday, the Shanghai Composite is close to bear-market territory, down 19% from its recent high, hit on June 12. A serious setback in China would have major repercussions, Barclays said, but it doesn’t expect that to happen.
Beijing authorities, who typically like to talk up the market when it encounters the inevitable air pockets, also appeared relatively unfazed. With the Shanghai Composite up 70% since the beginning of November and an average price/earnings ratio of 85 times (“nothing to see here,” commented Babson Capital), spurred on by margin buying by newly minted individual investors, the government seemed to treat the escape of some gas from this bubble with equanimity.
So, heading into halftime for 2015, Europe is at an impasse, with Greece saddled with debts it can’t pay and its creditors unwilling to hand over more cash without reforms. China, meanwhile, appears to be entering a bear market, despite massive monetary easing by its central bank as its economy slows. The consensus thinks these problems are contained. That, it might be recalled, is what was said about subprime mortgages in the past decade.
Back in the U.S. of A., the major market averages continue to hover around historic highs like a drone. And one of the prime factors keeping them aloft has been stock repurchases, but for how long?
Howard Silverblatt, the keeper of the statistical trove at S&P Dow Jones Indices, observes that 20% of Standard & Poor’s 500 companies have bought back stock in sufficient quantity to boost earnings per share by some 4% from the level a year earlier. That provides a tail wind going into second-quarter earnings reporting season, which begins in a few weeks. “Buybacks have now become part of the market support system,” along with low interest rates, he observes.
But buybacks are tailing off, according to BCA Research. The math is shifting as corporate bond yields creep higher, while earnings yields (the reciprocal of P/E ratios) edge downward; so, the arbitrage opportunity to borrow in the bond market to buy back stock has dwindled.
Moreover, BCA adds that corporate credit quality is deteriorating at the margin, and that buybacks tend to dry up when balance sheets swell.
The stock market’s dependence on the credit market is also noted by the perspicacious Peter Boockvar, chief market analyst at the Lindsey Group. The much-commented-upon weakness in the Dow Jones Transportation Average coincides with the backup in the benchmark 10-year Treasury note’s yield, from a low of 1.64% on Jan. 30 to 2.48% on Friday, the high for the year.
“I could be grasping at straws, but the transportation index peaked on Dec. 29, the utility sector [XLU for Utilities Select Sector SPDR fund] topped a day before the 10-year yield bottomed and is at a 10-month low, and the real estate investment trust sector [ iShares US Real Estate ETF (IYR)] did so three days before that and yesterday closed at an eight-month low,” he wrote in a note to clients on Friday. “These last two sectors are an obvious response to the rise in rates, but the Industrial Sector SPDR ETF [XLI] topped on Feb. 20 and closed yesterday at near a five-month low. The Materials Sector SPDR ETF [XLB] peaked on Feb. 24 and is at a 10-week low.”
Boockvar says he doesn’t know if this is because of global growth concerns, earnings worries, or consolidation of the gains of the past few years. “What I do know is that financial conditions continue to tighten, however modestly. It started with the end of Fed QE; it continued with the stronger U.S. dollar, which was then followed by the rise in long-term interest rates, which in turn has raised the cost of corporate capital as the Moody’s Baa yield index is at the highest level in almost a year and a half.”
What’s clear, Boockvar concludes, is that the markets will lead to the next recession, not the other way around, which historically has been the pattern. Asset-price appreciation has driven this expansion, and the previous two recessions were caused by their reversals after the dot-com and housing busts. “This is what happens when the Fed creates an asset-price-dependent economy, rather than the old days of asset prices reflecting the underlying fundamentals,” he concludes.
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