Pros and cons of Greek exit, as seen by Merrill Lynch’s Bill O’Neill

Bill O’Neill, chief investment officer, Merrill Lynch Wealth Management EMEA, discusses the likelihood of a Greek exit from the eurozone.

Last week saw the return of the next instalment of the Greek saga. The market has viewed events and come to the judgement that matters have progressed materially closer to tragedy (in the form of a Greek exit from the single currency). After a few hiccups, the hope was that the Greek President would succeed in putting together a pro-bailout coalition government in the wake of indecisive election results the week before. When this failed, the market lurched back into risk-averse mode as it became clear that the Greek electorate will be returning to the polls in just under one month’s time.

At this stage, it is important to make one point very clear: the base case scenario is still not for a Greek exit from the euro, even if the odds of it happening have increased. With a significant portion of Greek sovereign debt now owned by the official sector, it fell on other parts of the market to signal distress. At the conservative end of the spectrum, German bunds reached record low levels with 10-year maturities falling to 1.41%. U.K. gilts and U.S. treasuries have equally benefitted from the fear trade. As could be expected by now, other peripheral debt markets were under pressure, led by Spain where the 10-year yield rose sharply to touch 6.3% at one stage. This obviously raises the dual issue of debt sustainability and contagion.

Beware the dog that has not barked: credit markets are still resilient. While other risk markets have struggled in the current environment, credit markets are behaving with a surprising element of decorum. There are a few reasons for this. If the market is correct in not viewing a Greek exit as a trigger event for a global synchronised economic downturn, then there is no specific reason to fear a systematic rise in global default rates on credit bonds. One would expect local strain where there are concentrated Greek exposures but these would be small in a global context. At present, the global high yield default rate is running close to 3% on an annualised basis, with few in the market seriously calling for a spike.

However, it is evident that European high yield may be somewhat more vulnerable than the headline numbers would suggest, and certainly more vulnerable than the U.S. It has been the strongest market so far this year with a total return of nearly 10% by the end of last week. The European credit market (especially at the lower end of the spectrum) faces two headwinds that are less relevant elsewhere. The obvious one is of course a pretty challenging operating environment. Much of Europe is facing outright recession irrespective of what happens in Greece and recession is bad for credit. Second, with the banking sector under pressure to reduce balance sheet risk, refinancing risk will possibly come to the fore later in the year for European high yield bonds as well.

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