Greek Default And The Unintended Consequence Of Profound Certainty

by: Eric Parnell, CFA

It has finally come to pass.

It what has been an inevitable outcome for months, Greece defaulted on its debt this past week. Now that the credit event has finally happened, it is reasonable to consider what the fallout effects might be for investment markets if any going forward.

The initial stock market reaction to the Greek default news was generally positive. Of course, such a reaction was not a surprise, as it has been anticipated for months that a credit event was likely at some point. And global policy makers have been preparing well in advance for such an outcome including injecting massive amounts of liquidity to shore up bank balance sheets across Europe. Moreover, the default was handled in an orderly way through the Greek PSI deal that concluded on Thursday.

In the wake of the Greek default, stocks as measured by the S&P 500 Index (NYSEARCA:SPY) closed out the week on Friday still pressed right up against previous high resistance from May 2011. And they appear increasingly determined to break out to the upside in the coming days.

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Despite this initial stock market optimism, it will remain important to stay on guard against any potential fallout from the Greece situation in the coming days. This is due to the fact that the market reaction may not be immediate. Instead, it may take a few weeks before the effects of a Greek default begin to bubble their way to the surface and impact stock prices. After all, it took the stock market roughly two weeks after the collapse of Lehman Brothers in 2008 before it began cascading lower. Looking back even further, it took two to four months before the market came fully unraveled in 1931 following the collapse of Credit Anstalt. Thus, keeping a close eye on events as they unfold in the aftermath will be prudent.

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A variety of unforeseen consequences could potentially surface and disrupt markets in the coming days. Leading among these is a tangle in the settlement of CDS contracts that were triggered as a result of the Greek default. Or perhaps it will be the quick return of market jitters given the prospect that Greece may soon need to either return for additional rescue funds or contemplate their exit from the eurozone. These are just a few of the many potential risks.

While it is still possible we may see a market shock resulting from the Greek default, I consider this a lower probability outcome at this time. This is due to the fact that global central banks including the European Central Bank (ECB) has bent over backwards to provide as much support as needed for this credit event. And in the event that a systemically important institution still found itself in trouble in the aftermath of the Greek default, my belief is that the ECB would step in with whatever additional support was necessary to diffuse the problem.

My greater concern for the market lies down the road. And here is the reason why.

Not everyone wants to see the stock market go up. In fact, some investors like to see the stock market go down. And others don't really care what the stock market is doing because they are pursuing their own grand profit opportunities. In the end, it may be this last group that causes the most trouble for the eurozone and the stock market.

The problem going forward may end up having little to do with Greece. This is due to the fact that Greece is not the only country in the eurozone facing massive debt problems. As we all know, Portugal, Ireland, Spain, Italy and Belgium also all have major problems of their own. And in the end, it may be more likely that events surrounding one of these other nations may ultimately lead to the shock that proves insurmountable.

At issue is the following. Market participants did not know exactly how events would play out with the Greek situation. How far would the ECB go in providing support to Greece and the numerous at risk banks that hold Greek debt? What exactly would be the results of the Greek PSI? Would the International Swaps and Derivatives Association (ISDA) actually declare a default and trigger CDS in the wake of the Greek PSI? These were just a few of the many uncertainties associated with the situation in Greece, and some lingering uncertainties will be resolved as we move through the coming few weeks.

But now that the situation in Greece is coming to a resolution, we now have certainty and we now have precedent. And we now have a very good understanding and a road map of how these events would play out if any other at risk sovereign across Europe came under pressure. We now have a very good idea of exactly how far the ECB will go in providing support. We now have a very solid understanding of how the PSI process would work. And we now know exactly what threshold would cause the ISDA to officially declare default and trigger CDS.

Such certainty sounds like a positive, for it should give markets confidence about the orderly resolution of future credit events.

But in reality, it may very well prove to be a profound negative, at least in so far as the fate of the eurozone is concerned. This is due to the fact that a variety of sophisticated investors are bound to see opportunity associated with trying to force another sovereign default in Europe. And if they can succeed in pressing the issue, they now know essentially how to position themselves to maximize their gains in such an event. They now know exactly the targets to shoot at and can simply look to the Greek default episode as a guide to understand how policy makers are likely to react at each and every turn to adjust accordingly. And the bigger the sovereign they can succeed in forcing into default, the greater the potential gains are likely to be.

Perhaps none of this will come to pass. Perhaps the Greece situation will mark a turning point in the crisis and conditions will improve from here. Hopefully this is the case.

But given the persistent debt problems that continue to plague at risk sovereigns across the region, it may likely be only a matter of time before we see places like Portugal under fire. Or worse yet, Spain. If these nations were to find themselves facing the same fate in the months ahead, it should be recognized that selected private debt holders and other investors that have positioned strategically heading into any potential future episodes will be much better informed as to what to expect and how to profit. And maximizing this profit may ultimately involve an outcome that tears the whole eurozone apart in the end.

Given such lingering threats overhanging markets, maintaining a hedged approach in investment portfolios remains prudent. Stock allocations should be maintained, but in a proportion to other asset classes in a portfolio. After all, stocks are just one of many investment options to capitalize on opportunity. Emphasizing defensive allocations within this stock component is also worthwhile, as these stocks tend to hold up relatively better during periods of market turbulence. Moreover, defensive sectors such as utilities (NYSEARCA:XLU) and consumer staples (NYSEARCA:XLP) have trailed during the recent stock market rally and currently offer selected attractive opportunities. Representative names under this theme include JM Smuckers (NYSE:SJM), HJ Heinz (HNZ) and Bristol-Myers Squibb (NYSE:BMY). McDonald's (NYSE:MCD) may also be worth a look following their recent pullback.

Beyond stocks, an allocation to asset classes that can perform well in the current environment regardless of the direction of the stock market is also positive. These include steady performers such as U.S. TIPS (NYSEARCA:TIP) and Agency MBS (NYSEARCA:MBB) that have shown the ability to not only rise during stock market rallies but also benefit from capital inflows during periods of uncertainty. Precious metals positions such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) also make sense in the current environment marked by money printing and competitive currency debasement, although the recently high correlation between stocks and precious metals currently warrants close attention.

It will be important to closely monitor events as they unfold in the aftermath of the Greek default. While it may seem as though the market has brushed off this credit event, we may not know the true fallout effects for weeks if not months. And in the end, the true pain may ultimately come from a source far removed from the Hellenic Republic.

Disclosure: I am long BMY, SJM, MCD, HNZ, TIP, MBB, GLD, SLV, XLU.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.