- Scenario 1: Game of chicken
- Scenario 2: Greek exit
- Scenario 3: Panic
Scenario 1: Game of chicken
The most plausible scenario is that Greece clings onto its place within the euro by the skin of its teeth. The Greek government will probably seek to renegotiate the bailout, clashing with the European Union, IMF and European Central Bank. If those institutions suspend future payments, Greece would start running out of cash, causing markets to plummet worldwide.
Following tight negotiations, Greece would eventually adhere to the bailout requirements but only in return for substantial cash injections and interest rate cuts on existing loans.
In accordance with these events, we would expect Europe to fall back into recession, with unemployment rising throughout the second half of this year. Despite significant depreciation in the euro, trading activity would probably stay weak as foreign partners remain uncertain about the eurozone’s future.
As the eurozone crisis is felt throughout the world, Japan’s economy is likely to slow and remain weak into 2013. The yen’s strong appreciation would dampen foreign demand. For emerging markets, too, the eurozone crisis would likely to hamper exports. Growth would fall sharply with commodity prices decreasing in reaction to weakened global activity. The powerhouses of China and Brazil, however, should see growth pick up towards the year end.
Government intervention would boost China’s economic growth while Brazil benefits from robust domestic demand.
The UK would be teetering on the edge of recession, with inflation falling steadily toward target, supported by the recent sterling appreciation.
Scenario 2: Greek exit
This scenario would see Greece nationalising its banking sector after running out of money, following a continued clash with the EU, IMF and ECB. The ECB would have no choice but to force Greece out of the euro system. Consequently, contagion would quickly spread to Italy and Spain, prompting considerable market intervention by the ECB and plunging the eurozone back into a severe recession. As domestic demand collapses, corporate concerns about exchange-rate risk would halt trading activity.
A deposit guarantee scheme would be established to rebuild confidence, with the European Stability Mechanism receiving a banking license to support Italy and Spain. This would help both countries refinance in the primary markets until a European redemption fund became operational. Commodity prices would plummet initially but bounce back later.
Scenario 3: Panic
If Greece is forced out of the euro and politicians fail to provide an adequate policy response to ring-fence Italy and Spain, tensions would rise to unprecedented levels, with Italy and Spain struggling to refinance. Fears of a banking collapse in Spain could induce a bank run, forcing the ECB to inject a vast amount of liquidity into Italian and Spanish banks, in addition to financing their respective governments.
European panic would have a negative impact on economic activity in the US. The Federal Reserve would be forced to open credit lines to banks and embark on a third round of quantitative easing. Unemployment would rise quickly.
The Greek exit is the second most likely scenario. Thankfully, ‘panic’ is the least likely, but would be the most severe for the global economy.
Implications for investors
Despite the negative implications of all the above scenarios, there is light at the end of the tunnel for investors. Some markets within Europe are relatively shielded from the eurozone crisis and offer attractive valuations, including Germany, the UK and Sweden.
For cautious investors, put options can be incorporated into equity portfolios to protect against falling stock markets.
Corporate bonds offer some of the best opportunities among risk assets at present. Companies’ balance sheets are strong and profit margins are exceptionally high compared with historical averages. These factors should enable companies to meet their bond repayment obligations even if economic growth slows; default rates will therefore be lower than the rates currently implied by spreads over US government bonds.
