Friday, August 24, 2012

Greece Still Matters

With the Greek elections over and the resulting relief rally having soothed fears, investors are entitled to ask whether Greece should matter to them anymore. Unfortunately, I think the answer is yes.  Even if in the short term the markets will like the election result, there is a case for the resulting political set up to be making things worse.
The markets got what they wanted which was the a New Democracy/PASOK coalition Government being formed. The hard line left wing Syriza received a strong showing but not enough to stop a broad based coalition from ‘reasonably’ renegotiating aspects of the EU-IMF bailout program whilst receiving the bailout funds in order to keep Greece solvent. Problem solved?

Not a chance.

US Not Immune
US investors may think that US companies are immune but, this is not the case. A hard default by Greece would cause issues for the European banking sector and the economy, and then ultimately the US.

For example, McDonald’s (NYSE: MCD) generates more than 40% of its revenues from Europe. Any slowdown with European consumer sentiment will hit its top and bottom lines significantly. For Apple (NASDAQ: AAPL), it's 24%, but Europe generated 46% revenue growth for the company on a yearly basis. Again, a slowdown in Europe will hurt the company's growth plans.

Europe is obviously a key area for General Electric (NYSE: GE) and it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. Not only will its long cycle infrastructure industries be hit by a slowdown in Government spending, but GE Financial woud also be exposed in the event of a financial crisis.

As for Coca Cola (NYSE: KO), in the last quarter, it generated more profits from its Europe segment than it did from North America! Coke is seen as a defensive, but consumers can easily shift to a cheaper alternative. In addition, consumer staples are subject to slowdowns. A good proof of this can be seen in Danone's recent disappointments in Spain.

Merck (NYSE: MRK) generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics. The key point is that this problem is wide and pervasive that the traditional defensive safe havens will not work.
Greece Matters!

Deep Structural Problems, Not Short Term Fixes

If the problems are structural then the solutions must be too. Unfortunately, this refrain from leading German figures has hardly been heeded by Greece. Whereas Portugal and Ireland have won plaudits for their willingness and commitment to make reforms, Greece has proved reluctant or unable to implement them.
Moreover, the kind of reforms that Greece needs are deep and structural. Privatizations, asset sales and piecemeal liberalizations are useful for raising liquidity and dealing with short term funding issues, but they need to be accompanied by significant structural reforms of the public sector, fiscal policy, and political system. The bad news is that Greece is not satisfactorily doing the former, let alone contemplating the latter.

All of which leads to a curious clash of perception. Whilst the idea of the EU-IMF is that the bailout program is intended to buy time for Greece to reform and get back to a sustainable debt path, the Greek politicians seem to have other ideas. They seem to be playing a game of extracting as much lending as they can from the EU whilst not making the reforms, partly because they do not believe in them. Even if they did, it would arguably be impossible for them to make them in the face of an increasingly belligerent population.

The Curious Twisting of LogicWe can even see this reluctance to reform in the way that the lexicography of the sovereign debt crisis has evolved. Fiscal conservatism and sound governance has led Germany to historically low unemployment rates and good growth. Meanwhile high debt and public spending has scuppered prospects for so many across Europe. Moreover, under Baroness Thatcher, the UK managed to reduce debt and generate growth via an ongoing program of liberalizing reforms and fiscal conservatism.

However in France, Hollande was elected on a program of borrowing, government spending and opposition to reforms, all wrapped up under the slogan of ‘anti-austerity.’ In other words, if you argue against all the things that have demonstrably resulted in positive things for European economies, you are now to be labelled as ‘pro-austerity.’
The ‘anti-austerity’ light brigade are on the march in Europe, even though everything they advocate will make things worse. It is easy to promise the universal panacea of racking up debt for future generations in order to generate a short term high. Just ask a crack dealer. However, it is not a solution that will amount to anything other than more problems and debt for future generations. This is what got Europe into this mess in the first place.

Alas, politicians like Hollande are only encouraging Greece to carry on a concerted effort at refusing to make reforms. Indeed, with breathtaking audacity, many Greek politicians are advocating cutting taxes (which the Government has a hard time collecting anyway),while using EU money to invest in wide-scale public spending and not engaging in any more ‘austerity’ measures.

When will this madness end?

But the EU-IMF Have a Deal Right?

A deal is only as good as the intent of the parties to enact it. Unfortunately, the situation in Greece is that the parties being rewarded are those that have been explicitly against the reform program. Syriza’s position is well known, but what is little discussed is how vehemently the leading party in the forthcoming Government has been against the reforms.

The reality is that Samaras has continually garnered support by voting against reforms and generally causing problems for the existing Government. He even voted against the first bailout in May 2010 whilst expelling Dora Bakoyannis (a former foreign minister) for voting in favor it. He is arguably the most divisive and culpable figure in Greece’s failure to implement reforms.
And now the idea is that he is going to make the reforms while holding a coalition Government together with a slim majority, in a Parliament riddled with strong representation from Syriza’s collection of Marxists and hard left protagonists. Not to mention the neo-nazis, independents and communists in the Parliament.

To paraphrase Jim Carrey in 'Dumb and Dumber,' so you are saying there is a chance!

So What Next for Greece?

I think it is more of the same. The bailout will buy some time but it is unlikely that meaningful reforms will be made. The support for the ‘anti-austerity’ movement is likely to grow and Greece will revisit insolvency again. Meanwhile, the groups like Syriza who think they can ‘game’ Europe by threatening a hard default will become more emboldened.

The only route out of this cycle will be if Greece defaults (hard or soft) or, if a wide scale European solution (usually a euphemism for exposing the German taxpayer to other peoples debt) is enacted. I think the latter invites a huge amount of moral hazard that will inevitably condemn Europe to a low growth/high debt economy. The former is dangerous if done unilaterally, but probably manageable if carried out by the EU in a coordinated manner. A Syriza victory might have accelerated the process, but the New Democracy/PASOK coalition will likely keep the game going a bit more.

For investors, this means that the underlying risks are still there even if they are being swept under the carpet for now. Buyer Beware.

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