What the Greece crisis means for investors

Trevor Greetham, manager of Fidelity’s Multi Asset Strategic fund, looks at how the crisis in Greece and peripheral Europe may affect your clients.

Investors might be forgiven for thinking we have been transported back to 2008. The volatility of stock and bond markets over the past week or so has been an uncomfortable reminder of the gyrations that followed the collapse of Lehman Brothers. Now as then only massive intervention by the authorities in Europe calmed panicky investors and sentiment remains fragile.

As with the banking crisis in 2008, the sovereign debt crisis has been a long time in the making, with countries on the Southern periphery of Europe, most notably Greece, living beyond their means for many years. A combination of unsustainable working practices, generous retirement laws, a bloated public sector and endemic tax evasion have eroded the confidence of international investors that governments will be able to pay back their high levels of borrowing. Market concerns have been exacerbated by the fact a high proportion of these countries’ debts are owed to fickle overseas creditors.

Failure to reassure markets

Matters came to a head just over a week ago when the president of the ECB, Jean-Claude Trichet, failed to reassure markets the bank was acting decisively to prevent worries about Greek debt spilling over into other vulnerable European economies. Although Greece’s fellow eurozone member countries and the IMF came up with a €110bn support package two weeks ago, the fear was growing that speculators’ attention would simply shift to other heavily indebted countries such as Spain, Portugal and Italy.

A near 1,000 point fall in the Dow Jones index on the night of the UK election showed markets wanted much more from the authorities in Europe. They certainly got it with the launch of a co-ordinated €750bn package of measures designed to draw a line in the sand. Measures included a commitment by the ECB to buy up eurozone government bonds to short circuit speculative attacks on the countries with the weakest finances.

Stable UK coalition government

Concerns in Europe coincided with worries in the UK that an inconclusive election result would lead to a hamstrung government unable to take the necessary steps to reduce Britain’s budget deficit, which is higher even than the shortfalls in peripheral countries. The creation of an apparently stable coalition between the Conservatives and Liberal Democrats was, therefore, broadly welcomed by markets which were reassured that the £163bn gap between the UK Government’s tax revenues and spending commitments could be filled at a sensible pace.

The eurozone bail-out package of shock-and-awe proportions, coupled with new ECB lending facilities, certainly solves short-term liquidity shortages in the financial system and buys time for peripheral eurozone governments to tighten fiscal policy without a death spiral in the markets forcing them into default. It was no surprise to see a sharp rally in some of the hardest-hit assets like peripheral European bond markets, European bank shares and global stock and commodity markets in general – the Spanish stock market rose by 13% last Monday.

However, the initial market reaction is giving way to concern the package does not address the underlying weakness of peripheral economies which ever-larger government spending cuts will only worsen. Solvency concerns are likely to persist as the pace of the global recovery slows and I remain cautious about eurozone assets within my global portfolio, especially in light of Spain’s announcement at the end of last week that prices had fallen overall year on year for the first time since 1986. Deflation would exacerbate an already poor fiscal outlook as it would increase the real value of debts and interest payments.

Euro heads of state want to address a long-term structural debt issue by toughening up the eurozone’s original Stability and Growth Pact. But the problem is cyclical and more urgent. Peripheral economies were already under pressure to cut government spending as markets forced interest rates higher. They are under similar pressure now to cut spending if they follow the advice coming out of EU meetings or accept conditions attached to bail-out funds. In my view, this is not the right course of action. The recovery is fragile and the strait-jacket of the single currency means policy-makers can not offset the spending cuts with currency devaluation or additional monetary stimulus as would be possible in the US or UK.

Successful monetary unions like that between the US ease the problem by transferring tax revenues from more affluent regions to pay benefits in less fortunate areas. These transfers can be large but they are all but invisible and attract little political interest. The same cannot be said for transfers between member states of the euro-zone, where even loans between states provoke extreme emotions.

Fiscal transfers

The European authorities blame rating agencies, speculators and dysfunctional markets for the recent crisis. They are in denial about the need for large fiscal transfers, which in any case would require a much greater degree of co-ordination in terms of tax and benefits policies and perhaps a federal eurozone government to disburse the funds. The bail-out package eases near-term financial strains but offers no extra stimulus for peripheral economies.

Without anything to offset them, the risk is that spending cuts trigger a double dip recession in peripheral eurozone economies. If asset prices drop, banks will rein in their lending in an unpredictable way. Falling prices and lower wages in the troubled countries will see the one-size-fits-all interest rate tighten in inflation-adjusted terms, further accentuating the downturn. The situation could worsen further if tax revenues fall even faster than spending is cut. In the early 1930s when the US could not devalue or cut interest rates on the gold standard, Herbert Hoover attempted to balance the budget with disastrous results.

I hope sustained economic growth will start to refill government coffers but there are signs activity may be about to slow down and I worry the markets will go after weak players until it is clear this is nothing more than a moderation in the pace of recovery. There are real question marks over the survival of European Monetary Union without large fiscal transfers from one country to another. While the reluctance of stronger eurozone economies such as Germany to prop up their Southern neighbours is understandable, l do not believe loans are going to be enough. Since when did you help someone in too much debt by offering to lend them more?