Greece is the word

Greece's failure to repay €1.5 billion owed to the International Monetary Fund (IMF) on 30 June may have only a limited economic impact on the Eurozone (unless you are Greek) but its wider effect on financial markets and investors' portfolios remains harder to judge. 

The uncertainty may help to explain why the FTSE All-Share has just had its worst quarter since Q2 2013, with a 2.8% fall. It also provides a basis for why domestically-focussed sectors and indices, such as Household Goods & Home Construction and the FTSE 250, handily outperformed areas with greater overseas exposure, such as Autos & Parts or the FTSE 100, for example. Whether this theme of home comforts reflects the traditional market summer lull, concerns over Greece or something deeper remains to be seen but continued strength in sterling usually favours domestic plays, if history is any guide.

Debt dilemma

Greece is not officially in default, even if as joins Cuba, Iraq and Zimbabwe in owing money to the IMF. Failure to meet a €3.5 billion payment to the European Central Bank (ECB) on 20 July will leave Athens in default. European officials continue to argue this may not force Greece to leave either the euro, not least because there is no official mechanism for doing so, but whether there is appetite in Athens to stay in the fold, or in Brussels and Berlin to keep it there, is less clear. 

Sunday's referendum in Greece (5 July) will be the first indication but Greece's inability to service €323 billion of Government debt should be no surprise as this figure represents 180% of GDP. The only options to tackle this mountain of liabilities are as follows:

• Grow out of them or inflate them away. In the past Greece has devalued its currency to spark exports and growth but euro membership closes this route.
• Default on its debts. This is drawing ever nearer, leaving European taxpayers on the hook, something which is unlikely to sit well in Germany, Spain, Italy and the UK in particular.
• A restructuring of the debt, accompanied by meaningful reform. This is the only real option. Europe must accept Greece cannot pay and hammering its economy is self-defeating. Greece must improve tax collection, overhaul its public administration and liberalise labour laws. Greece needs time for all of these, via longer payment dates, lower rates and some form or write-off on its existing borrowings. If these are not on offer, an exit from the euro may be the least bad option.

Unfortunately, the Greeks themselves will feel pain in the short term whatever happens – default, euro exit or reform – but the reform and debt restructuring give long-term hope.

What it means

The implications for Europe, and therefore the UK, must be assessed in a three-dimensional way.

• Politics. Frau Merkel of Germany will not wish to cede concessions, for fear of encouraging the Spanish and Portuguese voters to go down an anti-EU path when they go to the polls later this year. For his part, Mr Tsipras got Syriza into power in Greece on an anti-austerity ticket so he will only be able to go so far, for fear of being unseated. Prime Minister David Cameron will no doubt be looking on with interest when the Greeks vote on Sunday, given his plans for a UK referendum on EU membership by 2017.
• Economics. Greece is less than 2% of Eurozone GDP. Moreover, the ECB may have also limited the scope for economic contagion, given the European banking sector now has limited exposure to Greece's debt pile. The ECB, IMF and the European Financial Stability Facility (EFSF) hold around 60% of Athens' bonds and loans so the risk has been transferred from banks in no small part to European taxpayers. 
• Markets. This remains the greatest unknown. A story in the International New York Times suggested hedge funds have shovelled € 10 billion in to Greek bonds and stocks in the view a compromise deal to keep Athens in the Eurozone and the euro would be found. If this proves to be wrong, someone, somewhere could lose money and lose it heavily, especially if they are using leverage. Experienced investors with long memories will remember from financial crises and bear markets such as those of 1997-98, 2000-03 and 2007-09, that it is leverage and a lack of liquidity that ultimately fuel financial market meltdowns, even if it is unexpected events that trigger them.

Bigger issues

Whatever the short-term ripples caused by Sunday's vote, investors will ultimately have to take a long-term view on three issues:

• The policy of using more loans to solve a debt crisis is not working. Even if Greece gets access to a new bail-out, the funds will go to paying off previous liabilities. The globe has more debt now than it did in 2007 so rapid increases in interest rates appear to be unlikely, placing a premium on income and also secular growth stories in a low-yield, low-growth world.
• Central banks could respond to any economic or market turmoil by delaying any planned interest rate increases or even increasing QE programmes. The longer rates remain anchored at zero, the greater risk of policy error and an eventual inflation and interest rate overshoot to the upside, according to a new report from the Bank of International Settlements. In the end, central banks want inflation to erode their debts in real terms, something holders of bonds (those self same debts) may need to bear in mind.
• The Euro's flaws are still clear to see. Monetary union without fiscal or banking union is not working and Greece is a major test. If Greece does exit, other nations may be egged on into thinking about it by restless electorates, tired of what they see as the cost of maintaining what is ultimately a political rather than an economic union.