KanalyBlog

How Will the Greek Debt Crisis Be Resolved?

Markets this week were volatile as investors weighed the news coming out of Europe concerning the potential bailout of Greece. On Thursday, European leaders pledged unprecedented support to Greece, yet they failed to provide any details of how the bailout would work. Of course, Greece is not alone among European countries with too much debt, which threatens to derail the budding economic recovery. As a result, the resolution of this crisis has significant implications for global markets.

For a fresh look at the European crisis and Germany's key role, we have included a report from STRATFOR, a highly respected geopolitical intelligence firm. For the article, click Germany's Choice.

Investors Take Flight From Risk

Despite generally good news on the economy and corporate earnings, global equity markets are in the midst of the steepest correction since the recovery rally began last March. The week's peak to trough decline for the S&P 500 was over 5%, and the index is now down over 7% from the January 19th high. A late flurry of buying allowed markets to stage a near 2% rally from the worst levels on Friday, and the Dow Jones Industrial Average managed to close above 10,000.

The catalyst for much of this volatility appears to be increasing fears of sovereign credit risk contagion. Greece is clearly in trouble, with a budget deficit of near 13% of the country's gross domestic product, and total government debt of 113% of GDP. Greece is a very small component of the global economy with an annual GDP of around $350 billion (about 2.7% of Eurozone GDP), but history is loaded with examples of small problems that ultimately caused substantial economic damage (remember how the risk of subprime mortgages was "contained").

However, rather than being simply a cause of the market decline, Greece is just another reason to be wary of lofty stock valuations following the huge rally from the March 2009 lows. In fact, stocks have struggled on several occasions since mid-January following the release of otherwise positive news. Some examples: nearly 80% of companies have exceeded earnings expectations; U.S. GDP expanded by 5.7% in the fourth quarter; and Friday's report of January employment was generally as expected and the unemployment rate actually fell. An old stock market adage seems appropriate today - "the reaction to news is more important than the news itself". Recent reaction to news suggests that good news is already priced into stocks, requiring significantly better news to drive the markets higher.

The one asset that has stood apart during the stock market's troubles has been the U.S. Dollar, which is closing in on a near 10% rally from its 2009 lows. As the dollar appreciates in a flight to quality, risky asset classes are declining, especially the ones that performed the best last year. We continue to remain cautious with a focus on high quality stocks and bonds.