Capital Flight
May 21, 2012

Global equities and commodities were battered by persistent worries over chronic eurozone crises and sluggish U.S economic data curbed investors' appetite for risk. The flat Facebook initial public offering did little to support stocks on Wall Street with the S&P 500 wrapping up another week of declines, finishing the week close to 0.7 percent lower. The FTSE All-World equity index fell 1.1 percent, over the week and is down 9 percent in May alone.

Investor optimism has cratered since the start of the month with many benchmarks tumbling to multi-month lows on fears that the global economy is too fragile to cope with an implosion of the European monetary union and the subsequent financial sector fallout. Concerns about the state of Europe have intensified after Moody´s downgraded 16 Spanish banks and Greece faces elections in June, which could lead to the country's eventual exit from the euro.

Europe´s already strained financial system is facing another dangerous new threat: a possible run on Greek banks. Greeks have begun pulling their cash out of banks at an accelerating pace in recent days as fear has mounted that the country will leave the 17-member eurozone. Greeks, worried that their euro-dominated deposits will turn into worthless drachma deposits, have withdrawn €1.3 billion over the past week. In a sign of the times, the stock price of the world's largest commercial printer surged by more than 10% in the last three weeks to its highest level in more than three years.

Highlighting the precarious shape of Greece´s banks, the European Central Bank (ECB) last week suspended lending to four undercapitalized Greek banks, forcing the institutions to turn to the Bank of Greece, the country´s own central bank, for support. With Greece struggling to maintain stability ahead of the June 17 election, a bank run is that last thing the country needs right now. With the deposit base disintegrating, the basic building block of a stable banking sector is eroding quickly for Greece.

The May 6 th Greek election generated a fractured Parliament, and postponed plans for the country to move forward with painful austerity. According to the original plan struck with creditors, Greece was supposed to approve austerity measures in Parliament and draw-up a blueprint by the end of May for reducing spending by €11.5 billion in 2013/2014. A new election would throw a wrench in the equation, pushing back the timeline for approval by the IMF/EU and implementation of austerity plans. With delays the order of the day, the probability of a Greek default is increasing.

Recent polls from Greece are showing that the anti-austerity Syriza party is capturing 22% of popular support: up five points from the election. A dangerous new game of chicken appears to be emerging where Syriza appears willing to call Angela Merkel's bluff. While Greece represents only two percent of the eurozone's economic output, its exit could lead to the disintegration of the entire monetary system. With no precedent for breaking up a monetary union, Germany and the IMF/EU may be the first to blink as the eurozone faces asymmetric risks. As I mentioned last week on Fox Business Television a Greek exit seems a virtual certainty. There may be no way to contain the contagion should Greece exit the eurozone, a process that could set off a surge in bond yields throughout the region. Capital flight in other indebted countries might result in a wave of bank failures, necessitating capital controls and bailouts by the ECB to insolvent financial institutions.

Although the ultimate outcome of the Greek political crisis remains unclear, it appears certain that maintaining the status quo austerity plan for Athens is unlikely. When the smoke clears, European officials will need to decide whether to stick to their principles or live to fight another day. The odds of a Greek exit from the eurozone have soared lately, but ultimately the decision will rest with Europe's leaders who may choose to buy Greece and Spain some more time until all the ducks are lined up in a row before taking action.

With markets in a tizzy and the European process being driven by politics rather than economics, investors are encouraged to head for higher ground. Investors have moved into products they consider relatively safe, such as gold. German 10-year Bunds have been in demand, with yields hitting below 1.4 percent for the first time last week. US Treasuries have also been a bastion of stability in this unfolding drama with yields in the low 1.7 percent range.

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