How The Greek Crisis Could Affect Your Portfolio

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

At the beginning of every month, I brief members on how MoneyGeek's regular portfolios have performed and comment on the state of the financial markets. In this update, Ill also explain how events in Greece could affect the world economy and the financial markets, which in turn can affect the value of your portfolio.

Performance of Regular Portfolios

The performance of MoneyGeek's regular portfolios for the month of June 2015 were as below:

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Slightly Aggressive portfolio.

MoneyGeek's portfolios did about as well as its competitors in June. While XEG didnt have the best month, the U.S. dollar strengthened and that boosted the returns of CAPE and BRK-B yet again. In hindsight, I probably brought XEG into the regular portfolios a bit early, but theres no way that I or anyone else could have predicted what would happen in the near future. I believe that eventually, the decision to include XEG will pay off handsomely.

Bond prices continued to go down in June. However, that could change in the coming months as Canada flirts with a recession. If the Bank of Canada sees the economy slipping further, they could cut interest rates again, which would lift bond prices and further depress the Canadian dollar, as explained in this article.

While the sorry state of the Canadian economy did make its way into the pages of newspapers, the headlines of those papers were dominated by the happenings in Greece. For the rest of this article, Ill explain why the events in Greece have investors worried, and how such events may affect the performance of our investments.

Parallels with Lehman Brothers

In order to understand the fears surrounding Greece, we need to take a step back and understand some of the events that occurred in 2008.

In late 2008, in the midst of the financial crisis, a big U.S. investment bank called Lehman brothers went bankrupt. The bankruptcy sent shockwaves across the financial sector and almost caused the collapse of the global financial system.

The bankruptcy meant that the clients of Lehman brothers no longer had access to their money. For example, if a large corporate client had a hundred million dollars in an account with Lehman, they would no longer be able to withdraw that money freely.

Still, the main problem wasnt the fact that Lehman brothers was too big. While investors and clients of the bank lost billions of dollars, the size of those losses on their own wasnt enough to bring the whole system down. Rather, the event led investors and clients to start wondering if other banks could suffer the same fate.

The largest clients of Lehman were the other major banks. Banks routinely lend and borrow from one another, creating an interconnected web of financial obligations. So when Lehman went down, other major banks suffered losses, which made them more vulnerable, which made the clients of those other banks more nervous about their own money. Such worry led those clients to withdraw hundreds of billions of dollars in a matter of days in the aftermath of the Lehman bankruptcy.

The loss of confidence in a bank can become a self fulfilling prophecy. As clients withdraw more money, the bank becomes more vulnerable to bankruptcy, which causes more clients to withdraw more money. The vicious cycle can continue until the bank does go bankrupt.

To combat the loss of confidence, the U.S. government stepped in and provided guarantees to the clients of the major banks. The government also injected huge amounts of cash into the banks, and rescued other financial entities that were in dire straits. These actions of the government eventually allowed confidence to return, which averted the disaster that was in the making.

Fast forward to today. Some people think that Greeces default and its possible exit from the European Union (and its use of the euro) could produce a similar reaction to the one that Lehman brothers had in 2008.

How Greece Could Cause a Financial Crisis

While the events in Greece are tragic from a humanitarian perspective, Greece is not a big player from a financial perspective. Greeces economy, as measured by its GDP, is less than 1.5% of the European Unions total. Greeces debt, at roughly 340 billion euros, is less than 3% of the total combined debt of all EU countries.

Instead, as with Lehman brothers, investors are worried about the possible effects a Greek default might have on the broader financial system.

A Greek default will probably incur losses on those financial institutions that hold its debt, which includes Greek banks. In addition, Greeces possible abandonment of the euro spurred Greeks to line up outside ATMs to withdraw cash. If Greece stops using the euro, their government will likely convert the Greek peoples savings into their own currency, which will probably not be worth nearly as much as euros.

These events have led some investors to worry about what might happen if the Greek banking system goes down. Other European banks could take losses in such an event, which in turn might shake peoples confidence in those other banks, which could lead the clients of those other banks to withdraw money en masse. In short, some people fear that a Greek default will start another financial crisis.

Furthermore, some people are worried about the possibility that other countries will follow suit and default. They worry that investors will become more leery of investing in the debt of other highly indebted countries, such as Ireland and Portugal. Such worry could push bond prices down, which would pull interest rates up, and make it very expensive for these countries to borrow money from the open market.

The rise in interest rates would makes these indebted countries more reliant on bailouts, which could lead to the same sort of butting of heads that we saw between Greece and the rest of Europe. If the negotiations between the indebted countries and the rest of Europe follow the same pattern that we saw in Greece, these countries could default and start another banking system failure, possibly leading to another financial crisis.

The Effect and Likelihood of a Financial Crisis

A genuine financial crisis such as the one in 2008 will have far reaching consequences. Investors will dump riskier investments in favour of safe investments such as government bonds. Since stocks belong to the category of riskier investments, stock prices around the globe will fall in proportion to the severity of the crisis.

Likewise, commodity prices such as oil and copper will fall because theyre also considered riskier investments. The exception to this rule is gold, which is often looked upon as a go-to commodity in times of crisis.

On the other hand, interest rates on government bonds will fall as investors buy them up. The U.S. dollar will appreciate further relative to the Canadian dollar, as investors prefer to hold U.S. government bonds over any other governments bonds, including the Canadian governments.

Because MoneyGeeks portfolios have heavy allocations towards stocks, the performance of the portfolios will suffer in the wake of a financial crisis. We saw a brief glimpse of this on June 29, when U.S. and Canadian stock markets fell by more than 2% each.

That said, while its possible for the Greek default to start another financial crisis, I personally think the chances of that happening are small. Heres why:

The Greek crisis has been going on for a long time. Greece received its first bailout in May 2010, which is over 5 years ago. The European countries handed the bailout to Greece precisely because of all the fears I mentioned in this article. Since then, European banks and governments have worked hard behind the scenes to ensure that a Greek default wont lead to a financial crisis. By all indications, they are now well prepared to handle recent events.

Also, no other country is in a similar situation as Greece at the moment. No other indebted country experienced an economic depression to the extent that Greece experienced, and as such, there is less appetite among the other indebted countries to play hardball with the rest of Europe. In fact, the events in Greece might serve as a warning to these other countries who might think about challenging the rest of Europe.

In summary, while the events in Greece, theoretically, have the potential to lead to another financial crisis, I think the risks of that happening are overblown. However, that wont stop newspapers from reporting on the doomsday scenarios.

When you read such articles, or when you read other alarming articles, please remember one thing about the media. The media makes money by attracting people to their site or publication using articles. The more sensational the article, the more likely people will want to read the article. Thus, the media has an incentive to take the most sensationalist angle on any story. This often leads the reader to come away with an exaggerated view of whats actually happening.

I believe that such is the case with the Greek crisis today. While tragic, I personally doubt that the events will have the same effect as the Lehman brothers bankruptcy. Investors around the world seem to be sharing this view, as stock markets have remained pretty steady so far.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.