Market Commentary - July 2015
“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world”
- Archimedes; Ancient Greek Mathematician and Inventor; 287 BC - 212 BC.
The Greeks invented leverage more than 2,200 years ago. Sure, it might have started with “physical” leverage, but it didn’t take long to apply the magic to money. “Give me enough bank debt and I shall move the world” -- and move it they have.
Failure to make a required payment on a loan, rooted in either inability or unwillingness, constitutes default. On June 30th, the last day of the calendar quarter, Greece officially missed its $1.7 billion loan payment to the International Monetary Fund. This note will focus on the history of defaults, causes of the Greek crisis, the implications going forward and how we are reacting.
History of Defaults
“Dionysius the Elder, tyrant of the Greek colony of Syracuse (405 – 367 BC) used promissory notes to borrow money from his subjects (1). Upon the due date, he issued a decree demanding all money in circulation be turned over to the government. Non-compliance meant death. He re-minted the one-drachma coins, reissuing them as two-drachma coins, and repaid the debt. “One may rightly claim for the tyrant of Syracuse the epithet of Father of Currency Devaluation” (1)
Reinhart & Rogoff state that “From 1800 until well after World War II, Greece found itself virtually in continual default.” (2) Or, through the prism of Forbes, “Greece has spent nearly 50% of its independent existence in default.” (3)
Greece, Portugal, or Spain defaulting on their debts are not exactly unprecedented events as evidenced by the Reinhart and Rogoff chart below.
Greece and the EU
European countries, ravaged by World War II, agreed, in 1952, to The Treaty of Paris. Motivated by the desire to improve their damaged economies and present a common defense against Russia, the early success of these efforts led, in 1957, to the development of the European Economic Community (EEC). The elimination of trade barriers between member countries helped all prosper and membership grew for decades with Greece, Portugal and Spain joining in the 1980s. In 1993 the EU, with the Maastricht Treaty, adopted the Euro as their common currency featuring a single voice in monetary policy. These agreements laid the foundation for Greece to access external debt at the “common” cost that represented the good credit standing of France and Germany. Although each individual country would retain complete control over their own fiscal (spending and taxing) policies, they would relinquish the ability to print money; an intrinsic flaw that commentators felt would eventually manifest in a situation just like Greece is facing.
Lack of fiscal discipline is where the trouble began for Greece. The country, as seen in the graph below, spent a higher percentage of its GDP on retirement benefits than any other developed country. (4)
Greece also failed to collect taxes necessary to pay for its profligate social spending. According to the OECD, Greece failed to collect taxes on ‘underground economy’ revenue equivalent to about 25% of its GDP.”(5) Michael Lewis wrote that when former Greek minister of finance, George Papaconstantinou, came into office in October 2009, “He found the country's 2009 budget deficit was 14%, not the previous estimate of 2.7%” and reminded Lewis that “we had no Congressional Budget Office.” (6) “In other words, checks and balances were not present.
Though Greece technically crossed the default line last week, the nature of the “clean up” will be impacted by the outcome of this past weekend’s Referendum called for by Prime Minister Tsipras. The resounding “NO” vote supported the recommendation of the ruling party and may change the nature of negotiations going forward, but in a manner that is impossible to handicap. The “NO” vote, despite the acquiescence of a default and breach of financial promises, might provide the Greeks with some delusion of financial freedom.
Implications for Greece
Greece now embarks on a tough journey. When Argentina defaulted in 2001 unemployment doubled and inflation erupted.(7) Reinhart notes that “Greece’s default in 1826 shut it out of international capital markets for 53 consecutive years. (8) With unemployment already at 25%, banks closed, and foreign imports at a standstill, Greece can ill afford any additional economic regression.
Implications beyond Greece
You may be asking yourself the question, what influence could Greece, with a total GDP equal to one-half of Walmart’s annual revenues, actually wield on global markets? (8,9,)
That quaint view may have held 20 years ago. Total Greek debt is approximately €242 billion. (10) Potential losers include the International Monetary Fund (€48 billion), The European Central Bank (€18 billion) and Euro Zone Governments (€52 billion) with the brunt of debt owed to Germany and France.
In addition to any direct financial damage, a Greek exit from the EU (Grexit) would significantly tarnish the credibility of the 16-year experiment with the Euro.
The Grexit and Financial Markets
Bonds may diverge depending on geography. U.S. domiciled bonds could temporarily go up in price and down in yield if there is a flight to quality around the globe. However, we would view this as ephemeral and have little interest in chasing longer term or lower quality bonds in today’s world – with already artificially depressed rates. European bonds could suffer if primarily Euro government lenders need to replace lost capital through substantial new borrowing. Fortunately, bonds in Spain, Portugal and Italy (considered the next weakest links in the Eurozone) all stayed steady after the initial default.
Stocks could exhibit increased volatility in the coming weeks. Markets may not respond favorably to additional uncertainty when already coping with a largely uninterrupted six-year bull market, the anticipation of rising interest rates and steady geopolitical noise. But, the actual history of defaults suggests that these concerns might be misguided.
On August 17, 1998 Russia defaulted on its debt and devalued the ruble in what would later be dubbed the “Russian Flu”. International stocks, seemingly the most vulnerable to Russia, were up 20% in 1998 and up another 26.9% in 1999. (11) An isolated incident? On December 26, 2001, Argentina defaulted on external debt, primarily held by U.S. banks. The S & P 500 dropped 22% in 2002, with most attribution given to the demise of the dot com bubble. The index more than made up for it in 2003 with a return of almost 29%.
- Greece is teetering, but not for the first time and not the only country to face this challenge.
- The failure of the Referendum could result in some dislocation of the financial markets, but history suggests it would be either minimal or temporary.
The Grexit and Your Portfolio
All of the preamble has been designed to set up this “juicy” part of the note – our plan to maneuver through the geopolitical/economic earthquake with our arms raised like Rocky standing on the steps of the Philadelphia Museum. Okay, we are exaggerating.
However, we would be remiss if we didn’t explain how our explicit approach to managing your money fits into this situation.
Exactly two years ago we wrote about Antifragile; a provocative book written by Black Swan author, Nassim Nicholas Taleb. To refresh, he referred to three possible states including fragile (a piece of glass), robust (home plate) and anti-fragile (things that not only survive under stress, but also thrive). His basic thesis rests on the fact that bad things happen unpredictably, and that the only reasonable solution is to avoid being fragile.
In one of the two recent historical examples of a major country default (Russia; 1998) the financial markets were impervious. In the other (Argentina; 2001) equity markets had a tough year (though unlikely caused by the default). Let’s use 2001 as an example of different investment approaches.
Assume aggressive investors chose to invest all of their money exclusively in an S & P 500 Index Fund. They would lose 22% of their portfolio in 2002. Tough year.
Those investors could sell but the result would be to make their losses permanent. Or, through either resilience or just plain inertia, they could sit tight and hope for a rebound. Indeed, the S & P 500 turned up 28.7% in 2003 so these investors, instead of locking in a loss of 22%, would have a fractional gain and a heck of a ride for the two years.
By contrast, suppose that those investors allocated 20% of their capital in 2002 into a more diversified portfolio consisting of equal parts cash and intermediate term bonds, large, small and foreign stocks. The loss in 2002 would have been 16% instead of 22% experienced by the pure stock investors. Both bonds and cash were up for the year. Then, instead of sitting tight, they exercised discipline and took some of their cash and bonds gains and rebalanced by adding to their stock holdings. In other words, they would have brought the portfolio back to a 20% allocation for each of the five baskets. Small and foreign stocks rebounded even more than large cap U.S. stocks in 2003 and, by adding to all the equity baskets when they were down, these investors ended the two-year period with a gain of 12% on their portfolio.
This strategy depends zero on forecasting, but instead, the holding of cash and the discipline to deploy it during uncomfortable market conditions. We have referenced Warren Buffet on this topic in the past; he loves cash because it serves as a call option on all other potential investments when opportunities arise. No topic seems to engender more controversy in the last couple of years than cash. Despite the near zero yield, cash provides the dry powder to buy in down markets.
Our overall commitment to asset class diversification and rebalancing actually thrives on volatility – a significant reduction in fragility.
The lever that Archimedes would apply to money comes in the form of debt – something that we make a concerted effort to avoid. Debt generated leverage creates “Financial MSG” – magnifying both good and bad returns. This expansion of the range of potential returns works perversely against our explicit goal of compressing the innate volatility of the financial markets.
We don’t have to move away from the heat in Greece (or Puerto Rico, which is suffering through a similar story today) because we “stayed out of the kitchen” to begin with.
Archimedes introduced leverage as a productive tool for exerting extra influence on the movement of physical objects. Greeks in the modern era, adding to their infamous past, used leverage to live beyond their means. Now we will see who can use leverage more effectively. Will the Greeks attain better terms on a bailout having walked away? Will Euro lenders leverage their position to extract additional financial concessions from Greece? Hard to say. What we can convey, with a high degree of confidence, is that we are committed to leveraging our experience, research and aligned interests toward the goal of keeping you as anti-fragile as possible.
- Foreign Bonds, an Autopsy: A Study of Defaults and Repudiations of Government Obligation. Max Winkler; 1933.
- This Time is Different; Carmen M Reinhart & Kenneth S. Rogoff; 2009.
- “Debt Defaults Have Greek History”; Forbes; September 28, 2011.
- Eurostat; Reuters; June 16, 2015
- Organization for Economic Cooperation and Development; OECD.ORG;
- Boomerang; Michael Lewis; 2011
- “What can Greece learn from Argentina's default experience?” BBC; June 30, 2015
- World Bank; 2013 GDP in U.S. Dollars.
- $460 billion per SEC Form 10Q; June 5, 2015
- Reuters; June 28, 2015. Debt exceeds 100% of GDP.
- Measured by MSCI EAFE Index.