Market underestimates political contagion of Greek default
Pioneer’s Group CIO, Giordano Lombardo comments on the Greek developments: Greek Referendum, next steps and the possible scenarios ahead, as well as their investment implications.
How Did Financial Markets React to the Result of the Greek Referendum?
As we said in our previous note, the result of the referendum would be a necessarily binary outcome. Against most expectations, including ours (as we have no secret insights as to Hellenic people’s psyche), the Greek people resoundingly voted “No” to the EU proposals by a significant margin – wider than the polls (or European politicians) anticipated. The market reaction has been relatively contained (as of writing), with peripheral bond yields widening marginally, modest declines in the main European equity markets, and the Euro mostly unchanged versus the US Dollar. This market response is probably a combination of two factors. Firstly, that the market thinks some hope remains for an agreement that keeps Greece in the Eurozone and prevents the collapse of its banking system. Secondly, that a scenario of a widespread contagion is considered unlikely thanks to the tools that the ECB is ready to put in action to protect European financial stability. What Are the Next Steps?
We see two main areas of action, one financial and one political. The first one is related to the ECB.
The ECB is due to meet on ELA (Emergency Liquidity Assistance). In our view, it is unlikely the ECB will raise the ELA, and in the Governing Counsel some will argue that the ELA should be withdrawn and that the “haircut” applied to Greek government bonds as collateral should be increased. However, while the ECB is a rules-based organization it is, at the same time, very reluctant to be the trigger for further deterioration of the Greek banking system. The ECB has not reacted to the expiration of the last bailout program and Greece’s default on the IMF loan last week. Our base case is that the ECB keeps the ELA at current levels while negotiations resume on a new bailout for Greece. The next big hurdle will be the payment due to ECB on July 20th– should Greece miss it, the ECB would have to change its stance. In the meantime, the Greek banks won’t re-open and it won’t be long before the €60 daily withdrawal limit is reduced, increasing the pressure on the Greek government to negotiate seriously.
But the most important action we believe is going to take place on the political front, because we don’t believe that the ECB alone can (or would want to) take the responsibility for this matter.
What Are The Most Likely Scenarios Ahead?
We see three most likely scenarios:
- No agreement is found: if, in the next few days, the EU institutions and the Greek Government fail to reach an agreement, then on July 20th, Greece will technically default when it misses a payment to the ECB. This will put further pressure on the already stressed banking system, as it will run out of Euros, forcing the introduction of IOUs (non-negotiable debt instruments) to meet wage/pension payments due at the end of the month. This will be a meaningful step towards Grexit from the Eurozone. This parallel payment system will likely come under pressure soon thereafter, leading to an increase in inflation and possible social unrest. In terms of the investment implications of this scenario, the probability of a Grexit has clearly materially increased in the last few days. The market is pricing that, even in case of Grexit, “financial” contagion would be contained, thanks to the potential backstop of the ECB and EU institutions. What the market fails to estimate instead is the political contagion.The outcome of the Greek referendum may weaken the moderate parties in the Eurozone, for example in Spain (where an election will take place in November) and in Italy. These parties have been more prone to accept austerity conditions and reforms and are encountering opposition both left and right. This internal political debate may weaken the momentum of reforms that are necessary to make the European recovery more sustainable on the long term. The financial implications of this scenario are difficult to predict, but hardly positive.
- Greece remains in the EU but leaves the Eurozone. Considering the strategic position of Greece in a geopolitical context (proximity to Turkey, extremist ISIS forces in Northern Africa, relations with Russia, etc.) Europe may decide to still support Greece with economic aid and keep the country in the Union, if not part of the Eurozone. Ongoing pressure from the US could add to this outcome probability. The financial implications of this scenario are similar to those of scenario 1, but with less hard-to-quantify political risk.
- Some manner of agreement is reached. The outcome (and timing) of negotiations is very hard to predict at this stage. In Germany (but also in other Northern European countries) Greek insistence on debt restructuring is particularly hard to digest and the leaders have to deal with internal opposition. On the other side, Greek Prime Minister Tsipras’ position, while strengthened at home after the vote, is weaker with the EU institutions after the last round of negotiations. The resignation of Greek Minister of Finance Varoufakis is probably a positive sign as to the opportunity for more productive negotiations. In this case, an agreement could lead to market relief in the short-term, while the medium-term consequence are more uncertain as political risk will likely resurface in the next election cycle throughout much of the Eurozone, as well as in the UK referendum scheduled for 2017.
In conclusion, even though we think that in the long-term, the next developments can be positive in any case (clarifying in either direction the future of the European project!), in the short-term the uncertainties associated with all three scenarios will remain. In addition, to varying degrees, these uncertainties will impact the monetary policy at the other main central banks – particularly the US and UK. They could decide to further postpone the first rise in interest rates if they judged the state of the global financial system to be relatively more precarious. This could support risk assets that, after six years of bull markets, are now stalling.
How Are You Addressing the Uncertainties Linked to the Greek Situation?
As we said last week, investors should consider dealing with the current market phase with a largely defensive approach, because we believe the rise in market volatility was to be expected. We believe it’s too early at this stage to take any drastic action, as all the scenarios above are based on a political decision process that is extremely difficult to forecast, and, with the impact of each scenario itself, unpredictable. The probability of Grexit has increased and while it is to an extent already priced in the market, the broad political implications are still uncertain. The next few days will provide a clearer picture as to how this Greek drama will unfold, but we reiterate the fact that volatility will remain extremely high and news-dependent. We suggest maintaining a cautious posture across all asset classes.
On income solutions, we strongly focus on the quality of underlying income generators. In the short term, these solutions could be impacted by market volatility, but the good quality of underlying assets would underpin the ability to meet the expected outcome.