Monthly Commentary
It has been a decidedly mixed to poor start for most asset classes in 2010. The primary driver for this underperformance has been the fiscal drama in Greece, which has disclosed a budget deficit of over 12% and a total government debt equal to 135 % of its GDP. The Greeks had been concealing the depth of their financial problems for years through derivative transactions and accounting tricks but as the true state of their affairs have come to light, investors have fled from their sovereign debt. This increases the cost of borrowing and raises the possibility of Greece defaulting as it will need to sell over $30 billion in bonds over the next couple of months to cover expenses and roll over debt that is coming due. The problems in Greece have spread to the rest of the European markets due to their exposure to Greek bonds and, more importantly, the threat of financial panic spreading to other fiscally unsound countries; Portugal, Italy, Ireland and Spain (which collectively with Greece have earned the endearing PIIGS acronym).
Financial markets have gyrated as rumors come and go of a possible bailout of Greece by its Eurozone partners. Truth be told, if Greece slid into the Aegean sea the only thing much of Europe would miss would be he nightlife on Mykonos island. It represents only 2.5% of Europe's GDP and is widely known to have lied about its finances from the time of its entry to the Euro. However, the potential contagion of a Greek default to its fellow PIIGS, especially Spain, would have serious impact on European growth and even threaten the continued viability of the Euro as an ongoing currency.
The normal course of action for a country in Greece's situation would be devalue its currency (either officially or through inflation) in order to make its economy more competitive. This is not a possibility because the Greek's do not control their own currency. Given this fact and the risks to the Eurozone if Greece defaults, it seems to us that the stronger European countries will find it in their best interest to bailout the Greeks. They appear to be struggling to do so in a way that inflicts enough pain on Greece to reduce the chances of other countries seeking a similar bailout while reassuring investors in the soundness of European sovereign debt and economic growth.
The crisis in Greece also has demonstrated that investors are still wary of systematic global risk. The downturn in European markets has been matched in emerging markets, even in countries with very sound financial positions. Other assets seen as more risky, such as REIT's and commodities, have also had negative or negligible returns. U.S. Treasuries, seen as the safe haven investment, have been the best performing asset class as investors become more risk averse. U.S. economic data has been moderately positive, though not as strong as could be expected coming out of a deep recession, but even U.S. equities have been more reactive to the news emanating from Greece than internal fundamentals. We expect that some kind of deal on Greece would cause a reversal of the risk aversion that has been in affect for most of 2010 while a deterioration of the situation could lead to a new phase in the financial crisis, this time with the focus on Europe.
No matter what the resolution, the Greek economy is in for a protracted period of pain and suffering. It is a lesson in how quickly over-indebtedness can cause a crisis in a nation and we wonder if U.S. policymakers have factored this into their fiscal plans. With that said we will leave you with this chart that compares the budget and fiscal deficits of the PIIGS nations alongside that of the United States.
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