Greece, Eventual Grexit, and European Asset Values

I am positive about European assets on a cyclical basis. European shares are cheaper than their American counterparts and European QE provides an underpinning for European sovereign debt. As long as Europe continues to muddle through, markets will continue to stay elevated. The biggest near- and medium-term risk remains Greece, however. Despite progress in negotiations, I still think an eventual Grexit is likely. How soon it occurs and under what circumstances could have a meaningful impact on asset values elsewhere in Europe.

Stock markets around the world are breaking records. The US, the UK, Germany and Sweden all have seen their indices hit all-time highs. Japan is at a 15-year high. The UK FTSE is at an all time high surpassing 1999 and the US Nasdaq is close to that point as well. It’s clear that economic performance is not driving this euphoria. Rather, it is the low rate environment which is causing investors to seek higher returns, pushing up lower rated bonds and shares. It would be nice to think this cyclical rally could continue forever. But it can’t.

There are numerous headwinds lurking in the background, which necessitate caution. For example, here are just three. Brazil will throw in two consecutive years of lower GDP for the first time since the early 1930s. China’s growth continues to slow. Europe will continue to grow at an anemic pace and austerity remains in place across the Eurozone. Let’s remember that the US side of this expansion is already 6 years old. So I find it hard to believe we are only mid-cycle.

All of this makes it hard to gauge how to approach the market. Macro hedge funds have under-performed the general market as the choppy environment kills one asset class at a time, only for markets in general to continue to rise. Ever since this cyclical bull market began, I have recommended sector rotation and asset allocation adjustment as one way to maintain caution while benefitting from the continued rise in shares. But the Greek case points out how tricky this is.

In 2015, for example, returns on Greek bonds have been the best in the world. Money managers who bought Greece as the polls showed a hard left party coming to power and then held on as they met with investors in early February and hammered out a deal with the group formerly known as the Troika this past week were rewarded with a return of 11%. The next highest level is Denmark at 4.2% versus a relatively meagre 1.2% for Treasuries. This encapsulates the problem, the rolling macro mini crises from the fragile five emerging markets to the energy high yield players to the crisis in Greece. Markets have continued to move up due to the backstop of central bank easing, despite the difficult macro environment. And while I think this dynamic will continue because the ECB has only just joined the party with quantitative easing, I still believe the world economy is slowing and exogenous shocks are likely.

In Greece, my early read of what to expect from a potential deal with the new Syriza government has proved correct. We have a deal in place, and the cautious approval from the Troika has been swifter than I thought. But the paradigm remains backloading as outlined in a recent article in German newspaper Handelsblatt. France is telling the EC that it wants to run deficits over 3% through 2018 because of the election in 2017. The EC is saying no and they are also cautious about Italy’s budget plans. In fact, Handelsblatt notes that the EC’s Pierre Moscovici told the France 2 TV station that France could receive penalties if its budget did not adhere to Maastricht guidelines. “A good agreement is always better than uncomfortable sanctions,” Moscovici said. 

Applying what we have seen in Greece and what kinds of negotiations we are seeing in France and Italy, it should be clear then that timetables get pushed back but adherence to deficit targets remains important for the eurozone. And that means that pro-cyclical austerity can and will be applied, even in Greece. The best Greece is going to get going forward is the kind of backloading they are getting in their extension deal plus a relaxation in maturities and in interest rates. But, of course, Greece already pays below market rates on its debt. Its yield is lower and its average maturity higher than any periphery country today because it has already received a restructuring on favourable terms. How much further can the debt maturity extension, interest rate lowering move go?

Judging from recent statements by Greek finance minister Yanis Varoufakis, not that far because he is saying a restructuring is coming.

“For one to be able to return to the markets for borrowing you need to meet three criteria: primary surpluses, restructuring of debt and investments,” he told Real FM radio. “I’m speaking about debt swaps which will significantly reduce the debt,” he said, when asked how Athens would achieve a debt restructuring.

Now, this is politics. So it is hard to gauge where the sensibilities lie. But my read of this statement is that Varoufakis is still intent on reducing the net present value of Greece’s loans significantly through a structure like GDP-linked bonds if he cannot get a writedown of principal. Syriza have signed on for an extension because the situation warranted it given the capital flight. But it sounds to me like Varoufakis is angling for a return to the previous discussion about debt writedowns and restructuring as the longer-term discussion.

And I think this is where the problems are. What I am hearing out of Germany suggests that even the present deal is meeting resistance in the ruling coalition, especially from the Bavarian CSU party, the sister party to Angela Merkel’s CDU. The Frankfurter Allgemeine Zeitung also speaks of hardliners within Merkel’s own party warning that the bailout extension deal is too lenient on Greece. If Schäuble and Merkel are able to sell this deal to their party then it would represent the best hand that Greece would get from the Germans at this time. There is no chance that the Germans would be able to move toward GDP-linked bonds or debt writedowns by June. It’s not going to happen. So right there, we have a problem.

I am not a Greek political analyst. So I don’t know the intricacies of Greek politics. But what I am hearing is that this deal also has problems from the Greek side given the Syriza electoral platform. The German finance minister continually points this out – I think as a way of selling the deal in Germany, by effectively saying, “see, they compromised too. Why don’t we?” But you can sell a 4-month extension as a necessary evil if it is a bridge to a more substantial deal without “extend and pretend,” as Varoufakis puts it. So, to my mind, what happens by June is going to be critical politically and economically.

Frankly, the prevailing acceptable social, economic and political framework in Germany is not compatible with the one in Greece. The reality is austerity did not work in Greece. It led to debt deflation. But a lot of people in Europe still think of it as a viable economic model. Germany believes in pro-cyclical austerity because they see their 2005 Hartz IV reforms as a model of what can and should be achieved elsewhere. Moreover, the Germans believe they can have a primary surplus and reduce debt exactly because they have a huge current account surplus. The belief then is that, if the eurozone as a whole gets a current account surplus too, the sectoral balance between private saving net of investment and a current account surplus will makes primary budget surpluses easier in the periphery. A lower euro will help get the eurozone to current account surpluses, leaving countries like the US and the UK to hoover up the goods and services Europe produces in excess of what they demand. That’s the model. But it is a model for Germany, certainly not for the eurozone as a whole or Greece in particular. Finessing this has been a struggle. I believe Grexit is close to inevitable over the longer term, irrespective of what happens in the short-to-medium-term. 

The upshot: yes, Greek bonds are the highest performers to date. But political risk is extreme – and capital controls, default and a Grexit cannot be ruled out as the necessary consequence of differing political agendas in Germany and Greece. This highlights the risk associated with European asset markets.

As for where yield pickup is cyclically interesting, it lies in the convergence play and quantitative easing. Rabobank has outlined where they see QE happening. And the places where the proportion of QE to existing government bond assets is the greatest where yields are relatively high is in Portugal and Spain.

Rabobank thinks the Portuguese-Bund spread will narrow at least 125 basis points. Second, on the convergence list looks to be Spain. And this convergence is effectively a reduction in redenomination risk because of QE – despite anything that occurs in Greece. It makes sense then that Spain and Portugal were the biggest hardliners on Greece in the Eurogroup, according to reports of the event. Those centre-right governments have the most to gain both politically and economically from maximizing the space between themselves and Greece. Implicitly what we see is a quid pro quo of austerity and reforms for quantitative easing, yield convergence and political power, with the ECB acting as the ultimate enforcer of this arrangement. If Greece doesn’t tow this line in June due to the politics of the situation, Germany is willing to permit a default and a potential Grexit if it comes to that.

None of this speaks to the secular risks associated with low growth and high debt in Europe. Sovereign debt is protected by QE as long as the real economy is pointing up. But a Greek default will infect the real economy elsewhere and will have unpredictable effects on banks and capital flows in the periphery. In a worst case scenario, the next downturn means another decoupling with Italy’s low growth and high debt as the key factor to watch.

For now, it is risk on. Caveat Emptor