Greek Prime Minister Alexis Tsipras has amplified uncertainty about Greece's future by announcing a referendum this Sunday on creditors' recent proposals for the country.
Greeks have been queuing in front of closed banks due to capital controls designed to stop huge deposit outflows. Sentiment among investors has taken a hit and in the markets, euro zone equities have suffered a setback.
But while investors' emotions may tell them to take cover at this point, we believe rationality is a better guide. Over the next six months, we think investors should hold more than normal in euro zone stocks.
We maintain this tactical overweight position despite recent elevated volatility. We believe the European Central Bank (ECB) can limit contagion to bond markets in peripheral euro zone states, if needed, by scaling up existing asset-purchase programs or activating other policy instruments.
This should provide a powerful backdrop for firms to go on increasing profits. Also, euro zone leaders will stand their ground, even with a bumpy road ahead.
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Ultimately, the ECB has the tools and determination to calm financial markets, as the central bank's governing council made clear last Sunday.
Further, direct financial and trade links to Greece are relatively small. Even an escalation in Greece is expected to have a limited impact on the remainder of the euro zone, provided financial contagion is contained.
The currency union's economic fundamentals are encouraging, consumer spending is picking up, companies are benefiting from low borrowing costs and a weak euro has let earnings growth resume from depressed levels. We believe this will continue.
In our view, Sunday's referendum, whatever its outcome, will lead to more talks. Navigating euro zone equities in the months of uncertainty ahead will require investors to watch three things: the bond market, corporate earnings growth and political unity among euro zone leaders.
First, if Italian, Spanish and Portuguese bond yields are not contained, higher borrowing costs could derail the cyclical recovery in the euro zone. If, for instance, yields on Italian government bonds maturing in 10 years were 2.5-3 percentage points higher than the yield on German bonds of the same maturity, this would warrant a review of the investment case for euro zone stocks.
However, ECB Chief Economist Peter Praet has made clear that the bank would make full use of measures in place and use "broad discretion" to activate other policy instruments if necessary, in line with the recent ruling from the European Court of Justice. This could include scaling up bond purchases, easing any issues in peripheral markets.
Second, as euro zone stocks have rallied strongly this year, we regard earnings growth as necessary to maintaining any overweight position. Momentum in earnings growth is presently broad-based. Companies in both core and peripheral Eurozone countries are performing well.
For instance, Italian firms increased profits by 27 percent over the past 12 months, according to Bloomberg data. And, apart from energy and telecom companies, every sector has seen profits grow over the past six months, with financial services and information technology firms leading the way.
Finally, a rift in euro zone ranks or conceding weakly to Greek demands could undermine confidence in European leadership. We believe leaders have the policies and mettle to deal with this situation appropriately. Handling previous crises, notably in Cyprus, has provided experience. Leaders have stood their ground so far. For us, this is a positive.
Our base case is that these triggers will not be tested. While we expect Greeks to ultimately accept their creditors' proposals, the ECB is ready to act forcefully if they don't. For now, investors in euro zone equities should look through any temporary volatility.
Mads Pedersen is head of global asset allocation and Tobias Hochstrasser is a strategist at UBS Wealth Management. Follow UBS on Twitter @UBS.
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