Greek Crisis Map: How to trade the crisis

Here are a few scenarios emerging from the Greek crisis which we envision for the EU and stock market overall. These scenarios are generated from a framework that describes where we are in the three phases of this crisis and the current risks from the three moving parts of an investment universe: politics, the economic cycle, and asset valuations. They are part of a complete Greek Crisis Map.

The four scenarios have constantly shifting probabilities, but at the time of writing this my estimates are:

• Extend-and-pretend light = 35%
• Extend-and-pretend to Japanisation = 45%
• Germany to the rescue = 15%
• Revolution and war = 5% 

Extend-and-pretend light: A disorderly Greek default with the lack of a strong EU response would likely trigger or be preceded by a “mini-crash” in stock markets. Greece decides to leave the EU and defaults on all of its debt obligations. This leads to further contagion risk as rates explode across peripheral Europe leading to more pressure on mainly Spain, Italy and Portugal. The market (STOXX50 futures) re-tests the low from 2009 at 1765 (now @ 2150), roughly a 20 percent correction. The crash is followed by capital controls in most of Europe and the reintroduction of the Drachma in Greece.  The Eurozone eventually splits in two – where the countries supporting the fiscal compact remain in the new core European Monetary Union, while countries like Greece, and maybe also Spain and Portugal devalue but then link their post-devaluation currencies to the new Euro, in a manner similar to how Denmark currently links its krone to the Euro. The unemployment and economic situation will see a low point as we enter 2013, but private savings will then be relatively quickly activated as governments are forced to reduce government consumption and incentivise private investments. This is the quick-and-dirty solution and the one which probably results in the smallest overall negative cost, as Greece’s action will give both politicians and central bankers the “bad example” which they can use to say: Either we do austerity and reforms now, or else!

• Investing in the extend-and-pretend light scenario: Cash is king! We would run 25-50 percent in cash – not to be afraid, but to have spare capacity to buy stocks and businesses in the event of panic. Don’t forget that when concerns are at their peak then the greatest opportunities present themselves. Some might also consider hedging pension positions by shorting CFD’s on overall indices like CAC-40, the EURO STOXX-50 or more local indices. Shorts should never constitute 100 percent or even 50 percent of a portfolio, but 25 percent “tail-risk” protection makes a lot of sense. This leaves 25 percent which we would use to own higher quality corporate bonds for income and staying power through the potential crisis. Core European fixed income - like German, Swedish and Danish debt - also offers some support, although the yields are very low. In some ways, the government has been a “free put” on the stock market, and when stocks fall, bonds almost always seem to manage to rally. 

Continuation of extend-and-pretend to Japanisation: For most of us and particularly Europe’s unemployed this is the worst nightmare. Politicians and policymakers will continue to cut rates and expand QE and other liquidity enhancement measures as a way of “supporting the economy”. This has been the modus operandi for all countries since 2009 and has been an abject failure. This will not necessarily stop them (think Japan), so the more the stock market falls, the more likely it is we will see more printing of money. There is a belief among central banks and politicians that you can eventually inflate all debt away. Ultimately, however, deflation will make the debt burden too heavy to lift and real assets will fall in price. The Nikkei is still more than 70 percent below its 1989 high. This will lead to a lost decade(s) – and will be the politicians’ preferred path as they only concern themselves with re-election and not tough reforms.

• Investing in the continuation of extend-and-pretend to Japanisation scenario: The perceived panacea of money printing means that you need to have assets and an investment horizon that will protect you through low growth, low yields and the increased odds of further Japanisation. Gold and tangible assets are the main diversifiers in this scenario. We suggest 25 percent gold/silver, and 15 percent in other assets like agriculture and energy. Investors can look to commodity ETFs or commodity CFD’s, depending on the trade horizon (ETFs for longer, CFDs for shorter). Cash again needs to be 25 percent to reflect the dislocation of credit, then 10 percent in corporate bonds and finally 25 percent in high yielding stocks (global names). This portfolio gives you real returns (inflation protected returns and allows you to wait out some of the further malaise). 

Germany to the rescue: The EU was constructed as a house without a foundation. A currency union without a political and fiscal union will never work. Furthermore, the effect of not having an EU Ministry of Finance is obvious for all to see today. Germany has always ended up supporting the EU at the last minute and so far, doing so has been relatively cheap. But now, for the current union to survive, Germany would need to sign an unlimited guarantee/transfer union for the rest of the Eurozone – something it can’t do according to its existing constitution and for which there is no political or popular backing. Germany is in a Catch-22 situation and fast running out of options. If however Germany finally caves in after an exit by two peripheral countries from the Eurozone, and a fiscal Eurozone is formed, and the ECB is allowed to go full throttle to devalue the single currency, then the Eurozone will be more or less “saved” in its current form. EURUSD would quickly retreat to less than parity (1.00). It would lead to downgrades of the northern/core EMU countries’ credit ratings, but the devaluation would transfer the short-term pain out of the periphery and would buy the politicians a few years of time for further change. 

• Investing in the Germany to the rescue scenario: This will buy the market some time to make the necessary reforms and to reduce the fiscal deficits over a longer and more realistic period. This scenario is far better for risk (watch out for currency risk though), meaning on the asset side that owning 50 percent stocks (with perhaps more weight on solid companies in peripheral countries which will clearly stay in the Eurozone and have fallen the most already), 25 percent corporate credit and 25 percent Spanish and Italian bonds is the way to go. On the currency side, being short EURUSD would be a must in this scenario. There would still be a lot of heavy lifting to do (and the persistent risk that this scenario merely morphs into the “More extend and pretend scenario” after an initial sentiment boost), but it would offer the least pain in the short term. 

Revolution and war: This is the least likely scenario, but in a major cyclical cataclysm like the one we are undergoing, it must unfortunately be considered. If this unlikely scenario unfolds, it might look like a replay of the crises of the 1920s and early 1930s. Back then, people lost faith not only in banks but also their governments. There was either monetary hyperinflation (Weimar Germany) or deflation (more common, but believe it or not – again Weimar saw the worst, as it had “learned its lesson” from hyperinflation). The lack of trust in - or lack of access to - currency resulted in near barter economies in many cases. This kind of situation leads to civil unrest as a family’s focus changes from wealth preservation to mere survival. The shock to the middle class radicalises the key element of the population that provides the energy for truly revolutionary fervour and change. This could bring on heightened risk of economic friction as countries turn inwards, launch sanctions and even trade wars (though hopefully we’ve too many nuclear powers in Europe to even ponder a military war, even in this scenario). Social unrest and political violence return like ghosts from the past. This scenario sounds far-fetched and perhaps it is, but it’s important to include and is cyclical. In any great historic crisis, there must be a dramatic phase where the entire old order is called into question and a new order is born, and this always brings plenty of dramatic change, which in turn is often accompanied by violence. The recent rise in extreme right-wing parties in Greece is a case in point and cause for concern, but let’s hope such impulses remain a fringe phenomenon.

• Investing in the revolution and war scenario: There really is no good strategy for this environment – buying physical gold, silver and other tangible assets is the only way. Though markets continue to function, solid companies with strong operations in their home countries (confiscation of foreign-owned mining companies is already becoming a problem) might be had for a song in the dark days of such a scenario, assuming they come out the other side intact. Owning farmland and having the ability and access to food becomes critical. This situation would mean a complete end to fiat currencies – those currencies that are merely backed by the faith and credit of the government, rather than by any physical asset. In this case cash not backed by gold or silver would quickly cease to have value as there is a risk of descent into a barter economy. Access to resources becomes all important.

It is important for me to add that I don’t believe I have any power to forecast the future. The scenarios (and supporting arguments) should be mostly seen as an attempt to provide a framework for envisioning and discussing how they might affect our investments.

This framework leads me to believe that we will get through this crisis, and that the low point will be short if rather painful. I also believe that the micro-economy will soon start to take over, exactly when the macro policies are more misguided than ever. Again, the key thing to remember is the grand irony that investment opportunities are at their best when the world looks its worst.