“Angela, we’re going to need a bigger hose…”

“Policy makers don’t understand that they are not in control. It’s not that speculators are in control, either, but rather that fundamentals actually matter.” – interview with Colm O’Shea, “Hedge Fund Market Wizards”, Jack D. Schwager, 2012

With recent elections across Europe going to anti-austerity/anti-bailout parties and Greek bank runs, individuals—who largely have been silent throughout the crisis (aside from the occasional protest or riot in Greece)—are reacting to the deteriorating fundamentals of the Euro Zone and are forcing change one vote and one (large) ATM withdrawal at a time.

The entrance of individuals as active players in the European crisis is a sign that the crisis has entered a new and critical stage. To date central bankers and politicians have been able to prevent flare ups from turning into full blown wildfire through policies and rhetoric that bought time, but did nothing to address the true structural issues associated with the Euro. However, over the last several weeks, European citizens’ actions at polling stations and ATMs have reignited the crisis and reversed nearly all of the stabilization policies put in place over the last 6-12 months.

As a result, the Euro is trading near its 2010 low (see Figure 1) and the odds that a country (Greece) will leave the Euro before the end of 2013 have increased significantly (see Figure 1): 

Figure 1 – The Euro is down over 7% from its recent local maximum at the end of February. Source: http://www.barchart.com 

Figure 2 – According to intrade.com there is a 57.6% chance that a country currently using the Euro will announce intention to drop it before midnight ET 31 Dec 2013. Source: http://www.intrade.com/ 

But, a Greek exit from the Euro in and of itself does not need to be a catastrophe for the entire Euro Zone and signal an end to the Euro. In theory investors have had more than enough time to prepare for Greece’s exit — most private investors (including European banks) have already realized significant losses on their Greek debt holdings due to the private sector debt swap earlier in the year.  This means that the direct financial impact of a Greek exit on European banks should be relatively contained because they have already taken the hit.

Policy makers now need to shift their focus to policies that actually address the true structural flaws in the EZ — i.e. that a one size fits all monetary policy for the whole EZ does not work without greater fiscal unity and economic burden sharing across strong and weak countries — and that mitigates the growing threat of contagion and bank runs, which have already started in Greece and to a lesser extent in Spain:

According to the Financial Times, “Shares in Bankia, the Spanish bank which was part-nationalised last week, plunged by over a quarter on Thursday morning, after a report that customers had withdrawn €1bn from the bank over the past week.”

Specifically, the threat of bank runs could be significantly reduced by providing some sort of assurance that bank deposits are not only insured against bank failure but also guaranteed against adverse currency conversion should the banks' home country abandon the Euro for a weaker currency.

On the surface individuals moving their money to ‘safer places’ like Britain, Switzerland, and Germany does not seem as bad as an entire country defaulting; however, bank runs can be incredibly insidious 

Figure 3 – 'Gross' anatomy of a EZ bank run. 

because once they start they are difficult to stop. This problem is further magnified in Europe where most banks hold a significant portion of their assets in their home country’s debt. When the bank is forced to sell assets in order to raise cash to meet withdrawals, they have to sell their country's bonds, which further destabilizes the country’s credit and in turn the bank’s (see Figure 3).

Without currency conversion protection, bank runs will become the most significant challenge that the EZ has faced since the crisis began.

Bottom Line: Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit and to devaluation threats from currency conversion.  To date European policy makers have been putting out flare-ups with buckets and a garden hose on a country by country basis, but have done little address the threat of a widespread wildfire.

Consequently, despite the temptation to buy into the rally in the first half of the year, we largely maintained our conservative stance. This conservative, slightly bearish stance means that our portfolios underperformed as the markets moved higher earlier in the year; however is now providing the protection that we desire as the crisis once again is front and center in investors’ minds and as contagion risks rise. This means we are:

• Avoiding everything European (equities, bonds, EUR, bank accounts, insurance, etc.) 
• Fully invested in safe-haven Fixed Income assets like US treasuries and other relatively safe bonds 
• Underweight Equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight Commodities that will be negatively impacted by slowing global growth (energy and materials) and that are inversely correlated to the strengthening US Dollar (gold) 
• Short EUR versus long USD 

Policy makers' actions and elections results (Greece is holding more in June) over the next several weeks will guide our positioning.  If we see signs that policy makers are addressing bank run concerns, or a renewed coordinated program by central banks around the world then we will selectively increase exposure. Until then, despite possible market moves higher, uncertainty remains too high for us to move significantly away from our conservative positioning.