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You may be asking yourself, "What the heck is going on in Greece?"
Investors not following sovereign debt or the capital accounts of certain European countries are probably looking at their portfolios and thinking, "What happened to the rally?"
Unfortunately, Greece happened
Last month, along with many others, I dubbed Greece the first in a whole line of dominoes and penned an article exploring the possibility that the EU could collapse under the weight of too much debt and an inability to coordinate among member-countries.
While the collapse of the EU is far from imminent, the second domino has certainly fallen. Actually, several dominoes have fallen.
1. This past Friday, Greece officially asked for the EU/IMF bailout package, which will provide the country with about $60 billion to help meet short-term obligations. Although this was widely anticipated, Greece was punished as risk premiums on Greek bonds soared. France and Germany certainly made a bad situation worse, telling the press that Greece must be held accountable for "unsuitable economic policies" and that the package won't keep other EU countries from being "firm" should Greece fall back on its economic reforms.
2. Yesterday, Standard & Poor's downgraded Greek debt to junk bond status. The rating agency said the downgrade was related to medium-term financing risks (we'll get to that soon), and it continues to hold a negative outlook on the country.
3. Standard & Poor's then offered a double whammy: It downgraded Portugal's debt two notches, saying it doesn't expect the country to stabilize its debt until 2013. Spreads on Portugal's debt, the amount of added effective interest investors require to hold riskier debt, rose to their highest level since 1997.
Downgrades do two important things -- they signal to investors concern over a country's ability to repay debt, and they typically make it more expensive for those countries to raise capital to pay off those debts.
Essentially, Greece has been living beyond its means for years. Think of Greece as a family that's maxed out its credit cards, taken out a second mortgage, and continues borrowing money to write itself a fat check even though it has no job.
Well, the markets have caught on, and that's why Greece is in the crisis it's in.
It wouldn't be that huge of a deal if Greece could manage some fiscal austerity -- increase taxes, boost productivity, enact pension reform, and cut federal spending. But historically, Greece has a bad if not terrible track record of being able to crack down when it needs to.
Oh, and then there's the rest of the PIIGS: Portugal, Ireland, Italy, and Spain. These countries, in one form or another, all suffer from high debt, low growth, and looming financial obligations. As we've seen with S&P's double downgrade of Portugal, when investors get more and more nervous about one particular country, the spotlight will inevitably shift toward the rest of the vulnerable pack.
Portugal, no doubt, deserves a different sort of attention than Greece. The country has a lower budget deficit than Greece, and its debt-to-GDP ratio is only 85%, compared to 124% for Greece. In addition, Portugal's Prime Minister, Jose Socrates, is a modern reformer and has demonstrated an ability to cut costs and shift the economy toward more in-demand, knowledge-based fields.
The problem, however, is that Portugal suffers from terribly stagnant growth. Real GDP growth has been the slowest in the EU since Portugal joined the group, and household savings have plummeted. When including household and corporate debt, Portugal's debt is 236% of GDP -- far above that of Italy and Greece.
The present fear is that Portugal will endure what Greece has -- a sort of self-fulfilling prophecy where market concerns dictate higher spreads, and higher spreads make it more difficult to raise money at reasonable rates.
What's next for the EU?
Well, first, the EU must realize that short-term financial backstops will only work for so long. Some sources reckon that Greece will need an additional $88 billion of long-term loans over the next few years, and that its debt burden will peak at 150% of GDP by 2014 -- the current EU/IMF bailout package does nothing to assuage these concerns.
Trying to alleviate immediate concerns is an admirable and difficult task, but if Greece is bound to default -- and it's only a matter of time -- then maybe it should just rip the bandage off and get it over with.
Second, other EU countries need to step up and start being more proactive. The chief economist for Portuguese bank Millennium bcp has said that "The [Portuguese] government is hoping that settling Greece's problems will help clear up the troubles and ease the pressure."
That ain't gonna cut it, Portugal. Step up and address the issues before they come to a head. Figure out a way to boost productivity and begin the process of lowering labor costs. As for the rest of the PIIGS -- do the same. Don't wait for a downgrade or soaring risk premiums to trigger some sort of declaration of domestic fiscal asceticism.
The bottom line is that the EU has a string of problems to deal with, and it needs to address them as long-term issues instead of just blips on their radar. As Nouriel Roubini stated, "Current EU/IMF plans to rescue the worst-placed of these countries -- Greece -- have drawn well-placed skepticism from markets as they fail to deal with core issues of debt sustainability."
OK -- so what should you do?
Considering the euro just plunged to a 12-month low, you wouldn't be remiss to short the currency using UltraShort Euro Pro Shares (NYSE: EUO ) or Market Vectors Double Short Euro (NYSE: DRR ) . Similarly, we can expect ETFs like iShares MSCI Europe Financials to see a drop: It fell by about 4.5% on Tuesday.
In the short term, be wary of companies that generate a lot of revenue from the PIIGS, those like Portugal Telecom (NYSE: PT ) or Eni SpA (NYSE: E ) . European banks have $159 billion of exposure to Greece, $93 billion of which is sovereign debt. Institutions like Spain's Banco Santander (NYSE: STD ) are going to feel more and more pressure, as evidenced by yesterday's 7.2% decline.
On a more positive note, every problem presents an opportunity, especially for the more risk-inclined investor. Personally, I like Telefonica (NYSE: TEF ) , a Spanish telcom provider that has significant exposure to Latin America, and at current prices, the National Bank of Greece (NYSE: NBG ) seems like a steal. This bank has a strong brand, significant growth opportunities in Turkey, and is one of the most well-capitalized banks in Europe.
The clock is ticking
I don't expect the trouble in Europe to end with Greece or Portugal. Watch over the next few months as other countries, most likely Spain and Italy, emerge with problems of their own.
The EU doesn't have the flexibility or the financial or political will to prevent what's coming. Maybe I'm dead wrong, and if you think so, please let me hear it in the comments box below.