Greece Votes "No." Is Grexit Next?

In a surprise to the financial markets, the results from Sunday’s Greek referendum showed voters overwhelmingly rejecting the terms of an international bailout. A “no” vote was not our base-case outlook, although it became more probable as the week progressed and no true Greek statesmen emerged to fight for the “yes” vote. In the end, Greek Prime Minister Alexis Tsipras convinced a voting public, who have supported continued membership in the Eurozone, that the referendum was an up or down vote on continued austerity and not on whether or not to remain in the Eurozone.

Is the next step a Greek exit from the Eurozone?

Greece had already entered into the course of a possible exit from the Eurozone last week when capital controls were enforced, and the banking system essentially ceased functioning. The rejection of further austerity and reform by the Greek public has now accelerated this process.

Tsipras has said that he wants Greece to stay in the Eurozone, but with a better deal than last offered. Significant concessions from both sides will be needed to stop and reverse the exit process. Dialogue between the parties will continue this week, and the European Central Bank (ECB) will continue to provide liquidity to Greek banks through Emergency Liquidity Assistance, but will not increase the level of support. It is possible that as the ATMs run out of cash (perhaps as early as this week) and the strain on the Greek economy worsens, the Greek government could be forced to make realistic concessions in exchange for a lifeline. Time is of the essence and the European creditors have lost trust in their negotiating partners.

We do believe that regardless of what happens next week, an exit from the Eurozone will require putting another referendum before Greek voters. The likely results of that referendum are unclear but a vote to stay in the Eurozone could lead to a collapse of the Syriza government and a return to negotiations. It won’t be easy and the odds of a Grexit are increasing.

Do we expect to see market contagion affecting other European countries?

In our opinion, the direct economic risk to the rest of the Eurozone is small, but the possibility of tightening financial conditions is real. Fortunately, the macro conditions across the periphery are much better than they were in 2011, as countries like Spain and Portugal have exited their own bailout programs and are both poised to grow in 2015. We expect core Europe to come up with further policy measures to help the rest of the periphery, including a possible expansion of the ECB’s quantitative easing program above and beyond what it is doing today. After initial market volatility, further policy support might not be a bad outcome for the markets.

Will the actions of the Greek government lead to a rise of anti-Europe governments across the periphery?

For this development to be of benefit to far-left parties across Europe the outcome of the Greek negotiations or a Greek exit from the Eurozone would have to be overwhelmingly positive. We are hard pressed to envision a scenario in which the European creditors would negotiate a deal that doesn’t include sizeable reforms and provisions that force Greece to become more fiscally responsible.

If Greece exits the Eurozone and 5 or 10 years from now stages a remarkable turnaround, then there could be a case for a rise in the anti-Europe governments. However, the costs of a Greek exit (including but not limited to rapid currency devaluation, massive inflation, severe loss of purchasing power, sharp increases in non-performing loans, and an inability to import essential items like commodities, food, and medicine), are unlikely to be viewed with envy by voters throughout the rest of Europe.

Currently there is little outpouring of support in the rest of the periphery for the anti-European governments. Podemos, the left-wing political party in Spain, which has called for the renegotiation of austerity measures, may get a boost, but it is unlikely to be sizeable given the additional looming collapse in Greek economic activity. There is no such movement in Portugal. Italy appears to be stable under Prime Minister Matteo Renzi for now.

Over the long term, we expect the legacy of the Greece crisis, irrespective of how it plays out in the weeks ahead, will be that it brings Europe closer together, not further apart. Additional steps that lead to it becoming a more integrated fiscal and banking union may be a positive result of the crisis.

How will the financial markets respond?

In European markets, we would expect to see a near-term flight to quality complete with lower interest rates in core European countries, declines in European equities, modestly wider interest rate spreads in peripheral Europe, and a stable to modestly weaker euro.

The U.S. dollar and U.S. Treasuries are likely to be near-term beneficiaries. The stronger dollar will probably act, as it did in early 2015, as a drag on U.S. growth and corporate profits, and that may put U.S. equities under pressure for the near term. Emerging market equities will likely decline and emerging market credit spreads may widen as money flows towards higher quality, U.S.-dollar-denominated assets.

Once the dust settles and further policy actions are enacted (including an expansion of the ECB’s quantitative easing program and an extension of the U.S. Federal Reserve’s zero interest rate policy), we believe the market response is likely to be favorable.

Want to read more from me? Visit News and Insights from OppenheimerFunds.