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No Default but Greek Induced Malaise

|Includes: SPDR Dow Jones Industrial Average ETF (DIA), QID, QQQ, SDS, SPY

Let’s be clear, the Hellenic Republic’s behavior is banana republic-like. Large deficit, strong unions and politicians unwilling to compromise, and even a system that cheats on the macroeconomic numbers as we recently discovered. Without intervention, the direction is clear: The first European Union default.

The consequences would involve a chain like effect by which confidence in the Euro would be broken, default on other countries would be expected and the whole EU could end. In other words, as the consequences are so devastating, then intervention of some sort is guaranteed.

The most active EU power is Germany which is at this point leading the discussions on how to put an end to the Greek Tragedy. Germany, a rich and advanced country, has paid for the EU stability and even shouldered the costs of its own unification. This position put it at the table of the great powers together with the other large European countries.

If the EU and the Euro were to break, then none of the European Union countries would be very powerful by themselves. But the EU is not only a geopolitical booster, but also a great economic booster by providing an immense market for German goods. In other words, Germany does not have an option.

Greek bonds are only backed by the taxation power of Greece. The European Central Bank is forbidden to provide a bailout and the Maastricht Treaty forbids an explicit German bailout as well -- there are loopholes in any case. Although investors have suffered significant volatility, they were right in assuming that there was an implicit guarantee for each Euro-zone country given the unthinkable consequences if things went south.

Considering how small the Greek economy is in comparison to the rest of Europe, then either Germany by itself or together with others can easily afford to support Greece. There are details that need to be worked out like IMF-type of conditions imposed by Germany; nonetheless we should consider it a done deal. 

French President Mr. Sarkozy and German Chancellor Ms. Merkel are expected to provide political support for Greece at the EU summit in Brussels this week, but they will be short in details. A final agreement may take longer than expected and if it takes too long, then pressure will mount quickly until a deal is forced.

The day after is where things could start to get complicated. After forcing the issue, investors could start pushing Portugal or Spain (my two favorite ones to follow).  Although a plan for those countries should be considered as part of the Greek bailout, we suspect that it may not be the case; hence in a few weeks investors will be selling Portuguese and Spanish bonds.

The end game will probably be one in which Europe gets serious about fiscal tightening forced by bond "vigilantes", but at a time it can ill afford it. The implication for the world economy is that one of the largest economic blocks will be plagued with malaise in the foreseeable future.

A brief market rally might follow the announcement, but it should be taken as an opportunity to sell stocks and/or establish short positions in the indexes.

Disclosure: Long QID, Short QLD