This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
The Jan. 25 election in Greece will determine not only its status as a eurozone member, but also the future composition of the euro area. Early in 2015, German Chancellor Angela Merkel stated that Greece’s exit would be manageable, 1 while some market punters see the European Central Bank’s (ECB) willingness to buy eurozone government debt as a factor that may minimize the potential for another Greek financial crisis. However, predicting the Greek election’s contagion effect isn’t easy, and investors may want to look at risk mitigation strategies to help weather the eurozone storm as it plays out in the coming weeks.
Potential election fallout
Will the Greek election weaken or solidify the eurozone over the longer term? There are plausible arguments on both sides:
- By purging the weak link, Greece’s exit could solidify European support for the eurozone. Or, if Greece decides to stay in the eurozone, that could also strengthen the region by settling the lingering exit question once and for all.
- On the other hand, a Greek exit could also ignite a broader movement. Spain and Portugal — stress points during the last wave of Greek turmoil in 2011 — may experience political discontent if Greece were to exit the eurozone this year. With Portugal expected to hold elections in September or October and Spain by Christmas, debate on the merits of eurozone membership seems probable after Greece’s political and economic fate becomes clearer.
Tracking low volatility through the Greek financial crisis
Low volatility strategies may provide an avenue for those looking to ride out the uncertainty surrounding the Greek election. While the past doesn’t predict the future and many factors drive equity prices, the relative performance of the S&P 500 Low Volatility Index during the Greek crisis in 2011 and 2012 offers insight into risk mitigation.
One way to monitor risk in the eurozone is by examining the 10-year government yields of countries that appear to be most prone to economic or political turmoil — specifically, Spain, Portugal and Italy — should Greece exit. In the graph below:
- The blue line compares the simple average yield of the Spanish, Portuguese and Italian 10-year notes to the German 10-year note. By comparing yields in the three vulnerable countries with the yield in Germany, the eurozone’s most stable economy, we get a picture of how the market is pricing risk. Going into 2015, the credit spread between the countries’ notes was quite low, which means the debt markets weren’t pricing great risk, with yields being pressured, in part, by hope for ECB quantitative easing.
- The red line shows the performance of the S&P 500 Low Volatility Index relative to the S&P 500 Index, based on weekly closing data. When we compare the red line with the blue line, we see that the S&P 500 Low Volatility Index outperformed the S&P 500 Index during each wave of credit stress in the eurozone.
The S&P Low Volatility Index Offers Insight Into Risk Mitigation
The table below highlights the chart’s underlying data during the peaks and troughs of the eurozone crisis in 2011 and 2012. Not only did the S&P 500 Low Volatility Index outperform the S&P 500 Index in each wave of credit stress, but the correlation between the relative performance of the S&P 500 Low Volatility Index and the eurozone credit spread measure is 0.68 (although it loosened materially in 2014).2 Though there is no assurance that a low volatility strategy will provide low volatility, this correlation between low volatility performance and eurozone credit risk offers support for the idea that low volatility strategies may offer a way to potentially ride out a credit storm.
The S&P 500 Low Volatility Index Outperformed the S&P 500 Index During Periods of Eurozone Credit Stress
Mitigating risk with low volatility
After discussing the merits of a low volatility strategy with their advisors, investors may want to consider it to help manage risks and ripple effects that the upcoming Greek election may trigger in the eurozone. PowerShares S&P 500 Low Volatility Portfolio (SPLV) is based on the S&P 500 Low Volatility Index. SPLV was incepted on May 5, 2011, as Greece’s financial crisis heated up, and weathered the spring of 2012 when Antonis Samaras became the new prime minister. More information on this exchange-traded fund and its performance can be found here.