Will A 'Grexit' Come To Pass?

Includes: IDV, IOO, IXP
by: Russ Koesterich, CFA

The Greek election earlier this month provided further evidence that despite all of the accords, firewalls and bailout funds, Europe’s economic future remains on a precipice. In a reflection of deepening economic malaise in Greece, the majority of the May 6 vote went to a number of far left and right parties, few of which ran on a platform of fiscal austerity or loyalty to Europe.

While the election certainly raised the odds of Greece eventually leaving the euro (as many market watchers have pointed out), it’s too soon to conclude that a Greek exit - or “Grexit” as some are calling it - is imminent. With it looking extremely unlikely that any of the Greek parties will be able to form a government, Greece’s fate now hinges on the results of a second election, expected to occur as early as mid-June.

Here’s a look at what the outcome of that election could mean for Greece.

  • If the June election does not produce a more definitive result and or the fringe parties emerge even more victorious: If this occurs, it’s difficult to imagine a scenario under which Greece will fulfill its various bailout accord obligations. Should Greece abandon its pledges, it’s unlikely that Germany and the rest of Europe will support additional funding and the risk of Greece leaving the euro goes up dramatically. Were this to happen, the reverberations would go well beyond Greece. While the European banking system is arguably stronger than it was a year or two ago, it’s still fragile, particularly in Spain. An imminent and disorderly exit from the euro would leave investors speculating on which country is next. Systematic stress is already evident with Spanish 10-year bond yields back above 6% and Italian bond yields creeping in that direction.
  • If the election produces a vote slightly more favorable for the two main political parties: The two main Greek political parties - New Democracy and the Socialists (PASOK) - traditionally capture between 75% and 80% of the vote. In the May election, they scraped by with less than a third. But a coalition government in Greece is still possible. Because of Greece’s parliamentary rules - the winning party gets a 50-seat bonus in parliament - the two main parties, even with their poor showing, came within a hair’s breadth in May of actually getting the necessary 151 seats in parliament to form a coalition. With 70% of Greeks still stating that they want to stay in the euro, the prospect of economic chaos may be enough to produce a better result in June. If the two main parties can scrape together a coalition government, Greece is likely to abide by most of the previous accords and remain in the euro, at least for now.

In the interim, volatility is likely to remain elevated, as I’ve warned before. As such, investors should consider:

  1. Focusing on large- and mega-cap dividend payers, accessible through the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA:IDV) and the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).
  2. Having a modestly higher allocation to defensive sectors such as global telecommunications, accessible through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA:IXP).
  3. Remaining underweight Italy and Spain.

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