Greece - The Final Act?

by Gavin Graham, Chief Strategy Officer July 29, 2015
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
This article is not intended to examine the details of Greece’s potential exit from the Euro-zone, which seemingly took a step nearer with its default on June 30th on the $1.5 billion it owes the IMF, followed on 5th July by the overwhelming 61% majority in a hastily called referendum against accepting the EU’s most recent bailout offer. However, proving that there are more twists and turns in the long drawn out process of Greece’s economic meltdown than in one of the classic Greek tragedies, the left wing Syriza government obtained agreement from the Greek parliament on 9th July to a more severe EU rescue deal than had been rejected in the referendum.

At the time of writing (July 12th) European finance ministers are discussing whether to accept the Greek government’s offer of higher taxes, less generous pensions and reforms of the inefficient and over-staffed government bureaucracy in exchange for advancing E70-80 billion in fresh funding for the bankrupt Greek banking system and the possibility of some debt relief.

Meanwhile, the Greek banks have been shut for 2 weeks, with local depositors only able to take out 60 euros a day from cash machines, and businesses unable to obtain funding for raw materials and supplies or to pay their staff, many of whom are now being laid off. Those analysts with a Machiavellian turn of mind are suggesting that the Syriza government deliberately engineered the showdown with the EU, the European Central Bank (ECB) and the IMF (known as the troika which has imposed austerity on Greece for the last few years).

Their intention, in this interpretation of developments, has been to show their supporters in Greece what leaving the Euro-zone would entail in terms of sacrifices, and enable them to get agreement to further austerity measures while remaining in the Euro-zone. If the EU agrees to the package put forward by the Greek government, then they will have achieved this.

Unfortunately for the long suffering Greek economy and its inhabitants, even another such debt relief deal will not solve the underlying problems. When Greece effectively defaulted on its sovereign debt in early 2012, with the interest rate on the debt being reduced and the maturities extended by 20 to 30 years, holders of government bonds of a member of the Euro-zone and the Organization of Economic Development (OECD), the club of wealthy countries, lost between two thirds and three quarters of their capital. This was the first default by a developed country in over 60 years, and more than halved the outstanding Greek debt. Three years later, the economy has continued to shrink, with the size of Greece’s GDP being 25% less than it was in 2010, unemployment is over 25% and youth unemployment over 50%. It’s no surprise that crowds of protesting Greeks have been gathering in Athens on a regular basis. The austerity programme and the grudging debt relief offered by Greece’s creditors have not helped the economy to recover, Greek productivity to improve or made the country more competitive as an exporter or a travel destination.

European stock markets ignore a possible Grexit.

One of the most confusing aspects of the developing European scene has been the strong performance of European stock markets this year and over the last 12 months. The EuroStoxx 50 Index, comprised of the 50 largest European companies by market capitalization, which includes UK (down 3.8% over 12 months) and Swiss (up only 3.1%) stocks as well as Euro-zone countries such as Germany, France and Italy, is up 8% over the last year, excluding dividends, despite all of the concerns over a possible Greek exit (“Grexit”) and the effect of sanctions against Russia, one of Germany’s major trading partners.

The German DAX is up 9.8%, the French CAC40 6.8%, Italy’s FTSEMIB 5.6% and the Netherlands 12%. Other southern European markets have not performed as well, with Spain’s IBEX down 2.8%, Portugal, regarded as the next most likely country to follow Greece’s path, down 18.5% and Greece 34% before its stock market was suspended on June 29th, the same day as Greece’s banks were closed to prevent them running out of cash. This performance compares to North American markets, where the Dow Jones is only up 3.9%, the S&P500 4.9% and the S&P/TSX is down 4.2%. Only the Nasdaq up 12.4%, and the Nikkei225, up 31%, have out-performed the Eurostoxx over the last year.

One of the main reasons that Euro-zone stocks have performing relatively well is that European Central Bank (ECB) Governor Mario Draghi, nicknamed “Super Mario” after his promise in August 2012 to do “whatever it takes” to rescue the Euro, has finally launched a Quantitative Easing (QE) programme. At the beginning of this year, he stated that the ECB would buy E60 billion a month of government and other suitable bonds for 18 months (i.e. until September 2016) even at negative yields up to -0.2%. This amounts to E1.17 trillion of stimulus, equivalent to $1.3 trillion at the present exchange rate of U$1.105=E1.

Euro-zone bonds in a bubble

This is the principal reason why many European short term bond yields became negative in the first quarter of 2015, as investors foresaw a coming bond shortage in the Euro-zone and associated countries such as Switzerland and Denmark. Investors were willing to accept negative interest rates on government bonds for as far out as five years; they bought at a price above 100, which is what the bonds will be redeemed at when they mature.

The yield on the German 10 year Bund, effectively the benchmark European government bond, fell from 1.2% in July 2014 to 0.05% in March, while yields on 2 and 5 year Bunds went negative, Similarly, yields on short term French, Dutch, Danish and Swiss bonds fell into negative territory, as investors persuaded themselves that the ECB would soak up all of the available Euro-zone bonds, and government deficits would fall as GDP growth picked up.

Proving that buying even the most attractive investment at the wrong price is a guaranteed way to lose money, European government bonds then experienced their worst quarter for twenty years as it became apparent that a bond bubble had been created, that the Greek problem had not been solved, and that European GDP growth was proving slower than expected, pushing up government bond issuance. German 10 year Bunds yields rose from 0.05% to 0.73% (July 10th), wiping out all of the gains made in the first quarter, although investors who bought a year ago at 1.2% would still have a positive total return of 5% (1.2% yield + 3.8% price appreciation). German 2 year yields are still negative -0.27% and 5 year yields are only 0.06%, but bond buyers have been taught a sharp lesson about buying at record low yields.

While the EU’s forecasts for German GDP growth in 2015 have increased to 1.9%, France is only forecast to grow 1.1% and Italy 0.6%. Those countries which have experienced the worst downturns, and actually carried out structural reforms, such as Spain, Portugal and Ireland are forecast to grow the fastest, along with those countries not in the Euro-zone like the UK and Sweden who allowed their currencies to fall against trade rivals. The Euro-zone and the ECB are now adopting the same policy, and allowing the Euro to fall against trading partners, to stimulate export growth to compensate for slow growth domestically.

Weaker Euro in prospect

Since its inception in 1999, the Euro has risen from U$0.90=E1 to $1.50=E1 in 2011, and has now fallen back to U$1.1=E1, touching U$1.04=E1 in March. With the US Federal Reserve having completed its tapering of its own QE programme at the end of 2014, the US dollar has been strengthening against other currencies running QE programmes, most notably the Japanese yen, which has weakened from Y80=U$ in 2012 to Y121=U$1 at present, a 35% decline. So far, the Euro has declined by 25% against the US dollar, and it is reasonable to expect further weakening in the Euro against other currencies. In January 2015, the Swiss National Bank (SNB) had to abandon its policy of shadowing the Euro, which had expanded its balance sheet enormously, and the Swiss Franc jumped almost 20% against the Euro in one day before settling down 10-12% higher.

European bonds remain extremely expensive and unattractive to foreign investors who do not need to hold them due to the Basel III capital requirement, as the European banks do. Then there is the currency to consider. Anyone considering investing in European stocks or bonds needs to take a weaker Euro into account, as the gains in local currency terms could easily be wiped out by the slide in the Euro. Even the 5% total return over the last year in German 10 year Bunds becomes a negative 14% in US dollar terms.

The longer term reason for the Euro’s weakness is that the ECB and the EU want it to happen, as a means of offsetting further domestic weakness caused by concern over which country night follow Greece out of the Euro. If some safety valve can be offered to less competitive economies such as the Club Med trio of Spain, Portugal and Italy through a weaker currency, and Germany can offset increased competition from Japan and South Korea in important export markets like China, then the Euro-zone can stagger on for a while. There are excellent world class multi-national companies that are located in Europe, and are selling at much cheaper prices than their US counterparts due to the concerns over the Euro. There’s no need to be in a hurry, however.

Once one country leaves the Euro, either in an orderly or disorderly fashion, as now appears likely to happen for Greece, then Pandora’s Box is opened (to use an example from Greek mythology).

Investors will begin to speculate about which country is next, the losses on the E350 billion of Greek debt held by European governments and institutions will erode their capital, and an attempt to achieve closer federal union in Europe through a common currency without getting agreement on fiscal union will reach its inevitable end. Once the dust settles, blue chips selling at reasonable valuations will be on sale, but the markets will experience high levels of volatility until some resolution is reached.