Climbing the Acropolis of Worry
When markets are said to be "climbing a wall of worry" it means they're rising despite mounting negative sentiment. I suspect the renewed concerns about Greece's debt crisis may be such a situation. As I wrote in my February commentary "Bull's Buck Is Not a Bust," I believe Greece may ultimately prove a distraction, which hasn't altered my view that European equities still have upside potential this year.
Political risk has increased…
The newly elected prime minister Alexis Tsipras and his radical left Syriza party may have rallied the masses, as evidenced by their convincing win in last month’s elections. But they have little experience negotiating with world leaders, including the “troika” of lenders — European Central Bank (ECB), International Monetary Fund (IMF) and European Commission. It’s also uncertain how strongly they’ll hold to their anti-austerity “mandate” when they take a seat at the bargaining table.
Greece’s government debt-to-GDP ratio is an outrageous 175%.1 If Greece does not seek to extend its bailout by the due date at the end of February, the country risks losing its next tranche of funding. It would also be forced to return 11.4 billion euros in European Financial Stability Facility (EFSF) loans.2 The government would default on IMF debt repayments in March and has a 7 billion euro redemption payment on ECB-held bonds due in July. These are sobering realities for the new government.
But isn’t insurmountable
Nevertheless, I believe a solution to the debt crisis is possible. Collecting taxes would be a good start, as abhorrent as it may seem to Greek citizens and tycoons. Greek currency in circulation is up 150% in the past decade but without any growth in government revenues.3 Fighting tax evasion is among Prime minister Tsipras’ initiatives, which is commendable but also insufficient.
More compromise and reforms are needed to keep Greece in the euro. Although European equities initially rallied on the announcement of the ECB’s quantitative easing plan, uncertainty about Greece may limit gains in the near term.
That being said, if a “Grexit” were to happen, the markets could be taken by surprise and volatility could spike in the short term. But my longer term view on European equities remains optimistic. I believe the ECB has sufficiently insulated other countries from contagion risk. Furthermore, Greece is small. Its gross domestic product accounts for less than 2% of the eurozone’s economic output.4 Finally, just as it didn’t pay to “fight the Fed,” it probably doesn’t make sense to fight the ECB.