Following the latest break-off in negotiations, the risk of Greece leaving the euro zone has clearly risen. Our analysis puts the probability at 30-40 percent. For investors, however, the good news is the European Central Bank is now more likely to react to broader contagion in case of a "Grexit." Even assuming a lag before it takes effect, the response should mitigate the impact of a Greek exit on non-Greek assets over a six-month horizon.
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Mario Draghi, head of the European Central Bank
As positions between Greece and its creditors differ and Greece's program extension ends in the coming weeks, negotiations may drag into July. Greece is becoming less likely to be able to service its bundled payment to the International Monetary Fund on June 30. Missing it may lead to capital controls, harm the economy further, and accelerate negotiations. Currently, we see a 40-50 percent chance of capital controls materializing. Missing payments to the ECB in July would tighten access to central bank liquidity, in which case the economic pressure may lead to an agreement.
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Despite electing an anti-austerity party, the population's strong support for the euro and the prospect of Grexit-induced hardship has forced the Greek government to keep negotiating. We expect this to continue for at least as long as the creditors do not issue an ultimatum. In contrast to prior years, the government's primary balance improvement means that bailout funds are now mainly needed to repay external creditors rather than pensions and state salaries. This has fundamentally changed and improved Greece's negotiating position.
On the creditor side, a Greek exit would put a question mark behind the European exposure of 320 billion euros to Greece through bilateral loans, European Financial Stability Facility loans, ECB-held bonds and the payment system of the euro zone. Who covers these losses if Greece defaults and exits the euro zone?
This is particularly challenging for governments tied to the straitjacket of the euro zone's fiscal compact with an independent central bank in the background. Notably, the IMF and EU Commission soon returned to the table after breaking off negotiations recently. What happens if Greece exits the euro zone? Even then, negotiations would carry on, as Greece would still owe 320 billion euros to euro-zone governments and more than 21 billion euros to the IMF.
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For investors, the good news is that Europe's policy stance has undergone a substantial evolution in the course of the negotiations. Not only is the euro zone as united on one issue as never before, but complacency has been replaced by concern. We continue to think the ECB would lead the policy response in case of an exit, possibly by expanding quantitative easing. Even Jens Weidmann, the head of Germany's central bank, recently said on contagion that "for me, it is decisive that we keep the currency union together as a stability union."
Hence, we think that any contagion-related damage would be contained on a six-month view. An exit could lead to economic headwinds. Nonetheless, the euro zone has a cushion in the second half of this year as monetary fundamentals and lead indicators are very positive. In the European government bond market, uncertainty would be very high immediately after the event. However, over a six-month period, we anticipate European sovereign bonds will normalize towards levels justified by the credit quality and current economic development of the countries involved.
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If a Grexit materializes, euro-zone equities would also be affected, mainly by the rise in sovereign bond yields we expect in Italy, Spain, and Portugal. But the negative impact on equities should be mitigated by renewed weakness in the euro, which is part of our core scenario in case of a Greek exit. Around 50 percent of euro-zone revenues are realized outside the euro zone. The value of those revenues in euros would experience upward pressure if the euro depreciates.
All in all, we could see a drawdown of 10-15 percent in the MSCI European Monetary Union equity index when Greece leaves the euro zone, assuming that the widening of credit spreads will be temporary. An ECB-led policy response should mitigate the impact on non-Greek assets.
To be clear, an agreement on reforms remains our base case. But given the continued deadlocks and the short time left in June, it is now possible that negotiations will carry over until next month, which is consistent with a higher exit risk of 30-40 percent. Nevertheless, investors should remember that the ECB not only has the power to prevent contagion, but is also prepared to use it.
As ECB President Mario Draghi said on Monday, "We can certainly say that we have all the tools to manage the situation at our best, as we have done in other instances perhaps as dramatic."
Commentary by Thomas Wacker, head of fixed income at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.