Investment Clock insights

Greek Euro exit risk


Trevor Greetham

6 July 2015

Fallout appears contained, probably an equity buying opportunity

Voters in Greece have rejected the terms of the eurozone bailout by a 61/39 margin in a surprise for the markets. As with the UK general election, opinion polls were finely balanced and dead wrong. Greece accounts for less than 2% of Eurozone GDP, however there is a fear that “Grexit” will create systemic risk in financial markets, which in turn will have a material knock on impact on the global economy. 
This memo outlines the political, economic and market issues as we see them at present.  Please note, the situation is very fluid.

The politics

Tsipras will try to use his democratic mandate as a platform for negotiating debt reduction and less austerity. Although there have been signs of a change in tone from the eurozone in the past couple of days, and some countries (especially France) seem to be more conciliatory, there is little time to construct a new agreement, which would have to be completely re-worked anyway, since the economic situation in Greece has deteriorated very quickly.

There is very little trust in Tsipras to actually implement the terms of any agreement, even a less onerous one, so it may be that the creditors try to force him out, in the hope of having a more amenable national unity government . They may want to send a signal to other electorates that this is what happens when fringe parties win. However this is a strategy not without risk, since it looks very undemocratic and may fuel anti-EU sentiment more generally. The forced resignation of firebrand finance minister Yanis Varoufakis may go some way to achieving the necessary rapprochement.

The economics

It should be clear early in the week if the Greek banks are to shut completely, since the European Central Bank (ECB) will have to decide on further Emergency Liquidity Assistance (ELA).  It should also become clear whether contagion has taken hold in other peripheral bond markets.  Until now, and including this morning’s reaction, there has been very little contagion seen in these markets (see chart).

Euro Peripheral Spreads

If this situation continues, and there are good reasons to believe that the ECB would step in if it felt peripheral spreads were under too much pressure, then there should be limited economic fallout to the rest of the eurozone. Even if spreads widen a little, actual yields are now very low, which would limit the economic impact.

There have been significant changes since the last crisis, which should continue to limit contagion risk:

  1. Economic growth has returned to the other peripherals (very strong growth in the case of Spain and Ireland – see chart) and these countries have ready access to bond markets.
  2. The eurozone banking system has little direct exposure to Greece*
  3. the ECB's Quantitative Easing (QE) and Outright Monetary Transactions (OMT) arrangements were not in place during previous period of euro stress

Spain GDP

Despite these changes however, there is still a latent fear in markets that these defences won't hold, since they have never been tested until now. Such a fear can feed on itself and eventually become self-fulfilling. It is not our base case, but there is a non-negligible risk that there will be a hit to general economic confidence outside Greece. Coming at a time of uncertainty over the pace of economic recovery in the US, not to mention the perennial fears about "something bad happening in China", market chat could become quite extreme. There will be talk about a delay to Federal Reserve (Fed) and Bank of England (BOE) rate hikes, which is to be expected: if the Greek situation is still "live" by the end of the summer, the Fed will be very reluctant to hike. There will also be some more extreme talk, of a material financial shock to the global economy and a move back into recession. With central bank cupboards looking rather bare, the conclusions will become rather grim.

The markets

Markets are unruffled by the presence of an extreme left wing government in Greece, or whether its debts are paid (most people accept the debt is unpayable). The real fear is contagion and a re-run of 2010-12. While to some extent markets had begun to price in “Grexit” risk over the past few weeks, and especially following the decision to call the referendum last weekend, in the near term, we could see a further sell off in risk assets and a rally in so-called safe havens (government bond markets).

The situation will remain unstable for the next week or so, so even rallies in risk may be short-lived. The general atmosphere is bound to be skittish until things settle down. However, volatility is usually higher in thin summer trading and investor sentiment is already depressed.

Sentiment indicator

Longer term, these "panic" events often turn out to be excellent buying opportunities for equities, even if it feels very tough to do so at the time. Our asset allocation position is overweight equities and underweight bonds and, if anything, we are minded to add to equities on weakness rather than reduce positions. The acid test for us must be contagion. If we see any significant pressure on euro peripherals, even with the ECB active in the market, then we would become more concerned.

Potential scenarios

  1. The eurozone doves win over Merkel and seek a renegotiation with Tsipras
  2. Economic stress leads to fall of Tsipras government within days. The new government negotiates a new deal with the eurozone
  3. Events move so fast that the Greek banking system collapses, the government introduces IOUs and Greece is effectively forced out of the Euro within days. In this case the ECB would intervene to stabilise markets, initially verbally, but actively if needed, perhaps without reference to the capital key
  4. Greece could leave the euro ‘temporarily’, using a parallel currency until its banking system and national finances are stabilised

Conclusion

In the short term, the situation is probably containable, given the key changes in the eurozone since 2012. Whatever the outcome, the bottom line is that Euro as presently constructed, is not a fully functioning currency union. It is essentially a political construct, and this will always be its “achilles heel”, until there is a fully functioning fiscal and social union (unlikely in our view). There is no demonstration of a eurozone-wide government, hence the situation where one government seeks to play its own electoral mandate off against another. The Greek template suggests that other euro area economies suffering persistent weakness will not be able to ease monetary policy independently or devalue their currencies and fiscal transfers from other nations will not be forthcoming. The risk of populist anti-euro governments rising to power in other countries could potentially spread over Europe, especially if Greece leaves the euro, devalues and eventually regains control of its destiny in the way Iceland has.

The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice.