By Henry To, Forbes
Earlier last month, we discussed why the chance of a long-term solution to keep Greece in the Euro Zone was slim, due to three reasons:
1) Currency unions such as the European Monetary Union can only work in the long-run if wealthier states directly subsidize poorer states with no strings attached. For example, U.S. states such as New Mexico and West Virginia have consistently received more funds from the federal government than they collected in taxes. These ‘state subsidies’ were supported by funds from New York and Delaware;
2) Different states or nations within currency unions generally do not have similar economies or even similar economic cycles. For example, Germany is currently running the largest trade surplus in the world (218 billion euros over the last 12 months, surpassing the size of China’s trade surplus), while France is running a trade deficit. This means there must be an easy way for workers and families to relocate from impoverished to more prosperous areas where jobs are available in an effort to balance out economic growth. Before the end of the U.S. shale oil boom last year, many workers and families flocked to Texas and North Dakota in search of better opportunities in the U.S. shale oil industry;
3) At 317% of GDP, Greece’s debt load (which includes government and private debt) cannot be simply reduced through austerity measures or a lower euro. A recent McKinsey study argued that while there have been some historical examples of debt reduction, this was usually achieved through strong economic growth or a sustained period of austerity measures backed up strong political will. For example, Canada was able to reduce its debt from 91% of GDP in 1995 to 51% in 2007, but this was driven by strong global economic growth and rising commodity prices and exports. Similarly, at the end of World War II, the U.S. debt ratio stood at 121%, but the U.S. was able to reduce its debt levels through two decades of virtually uninterrupted economic growth. Neither option is available to Greece; global economic growth is beginning to slow down again while pension and healthcare payments to millions of retiring baby boomers will drain the coffers of all European economies for years to come.
Unless Greece’s substantial debt levels are restructured, I believe Greece will need another “bailout” program again in a few years, especially if world economic growth slows down again. In our investment newsletters to clients, I have previously pegged the chance of a Greek exit as between 25% and 50%, within a 3-year time frame. But with Greek deposits now hitting a 10-year low to just 140 billion euros (down from 147 billion euros when we wrote about Greece last month)—and with the Greek government sure to run out of funds this month (unless a deal with the European Commission is struck)—a Greek exit may occur as soon as this summer.
Five years after Greece’s first bailout package, the Greek economy is worse off than ever. The Greek unemployment rate is at 26% while the country’s youth unemployment rate is over 50%. Since we last wrote about Greece, the country’s borrowing costs have continued to rise (the Greek 10-year government bond yield just made a two-year high), while Greek equity prices have continued to plummet.
It is not clear that Greece could strike a deal with the European Commission to stay in the Euro Zone this time around. A recent poll by German broadcaster ZDF suggests that the majority of Germans no longer wants Greece to stay in the Euro Zone. It has also become clear that the two bailout packages (totaling 240 billion euros) thus far were not sufficient and that any “piecemeal” effort will only continue to hamper Greek economic growth and deter further economic investments due to the ongoing political and economic uncertainty. What Greece really needs are direct cash subsidies, a significant haircut of its debt, and for the European Central Bank to directly purchase its debt so the Greek government could regain access to the financial markets. Neither the Germans nor the European Commission are willing to accommodate Greece; nor does the Greek government want to abide by its original bailout terms.
Moreover, from a Greek perspective, it is not clear that countries like Spain or Portugal are necessarily better off by staying the euro even though Spanish and Portuguese borrowing costs have declined. For example, unemployment rate in Spain remains elevated at 23.7%, while the country’s total debt-to-GDP ratio sits at 313%. Meanwhile, the Portuguese unemployment rate is at 13.5%, but its total debt-to-GDP ratio sits at 358%, which is above that of Greece. I believe a Greek exit from the Euro Zone is almost a certainty. I am currently evaluating three investment opportunities in order to prepare for a Greek exit:
1) A Potential Buying Opportunity in the Euro
A Greek exit will be chaotic even though many banks and traders have prepared for the event since it was initially discussed five years ago. More investors will leave the Euro Zone and the euro will likely decline further against the U.S. dollar. That being said, with the euro now trading at $1.10, it is now at 11% below its 200-day moving average against the U.S. dollar. Since the inception of the euro, there have only been three instances when the euro hit such oversold levels (11% below its 200-day moving average) against the U.S. dollar.
In addition, the International Monetary Fund (IMF) recently reported that emerging and developing economies dumped more than 100 billion euros from their foreign exchange holdings during the last six months of 2014 as the euro fell out of favor with central banks and foreign governments around the world. While I believe a Greek exit will put more downward pressure on the euro, I also think both the European Commission and the European Central Bank will do whatever it takes to keep the Euro Zone intact upon a Greek exit. Should the euro decline to a 1-to-1 exchange rate with the U.S. dollar, for example, the euro could be a good, short-term buy. Investors who are interested should research the FXE ETF.
2) Greek Stocks Are Cheap And Could Offer a Good Long-Term Buying Opportunity
Upon a Greek exit, Greece will devalue its currency. Most likely, capital controls will be implemented to stem deposit outflows while the country recovers from a currency devaluation. Greek citizens who want to protect their assets could purchase gold or Greek stocks. Greek equities make sense as a currency devaluation allows companies to lower their labor costs, thus protecting their profit margins (even better if the companies are exporters and thus making their sales in U.S. dollars or euros). The Global X FTSE Greece 20 ETF, GREK, holds the top 20 companies listed on the Athens Exchange by market capitalization. It is trading at a cheap 9.4 price-to-earnings ratio, and a 0.7 price-to-book ratio. I believe the cheap valuation of Greek stocks could attract both global and Greek investors if Greek stocks initially sell off as a response to a Greek exit.
3) U.S. Treasuries Are Still Cheap on a Relative Basis to Euro Zone Bonds
The U.S. 10-year Treasury yield is currently at 1.84%, versus the German 10-year government yield at 0.19%. The spread (i.e. the difference) between U.S. and German long-dated government yields is close to a 30-year high. I believe U.S. long-dated Treasuries is attractive on a relative basis, for two reasons: 1) European investors are now looking for higher yields since many European government bonds are yielding zero or below zero. U.S. Treasuries provide an attractive option as they are safe; meanwhile, the U.S. dollar will strengthen further if Greece exits the Euro Zone, and 2) this is not directly related to a Greek exit, but Friday’s disappointing jobs report should fuel more fund flows to U.S. Treasuries as investors push back the possibility of a Fed rate hike this year. One ETF that we like in this area is the iShares 20+ Year Treasury Bond ETF, or TLT.
