By Bill Witherell
Both sides in the Greek drama cling tenaciously to their dangerous but all-too-predictable brinkmanship tactics as the clock approaches midnight. In Berlin, a summit meeting of the leaders of the main creditors – German Chancellor Merkel, French President Hollande, European Commission President Juncker, International Monetary Fund (IMF) head Lagarde, and European Central Bank President Draghi – drafted earlier this week a “final” bailout deal that was presented to Greece Wednesday. It is notable for its reported “take it or leave it” nature and for the fact that the creditors have come together in a united front, bridging differences that Greece had been trying to exploit. Greece, for its part, has submitted its plan for avoiding a Greek default.
According to reports, while the creditors have made some concessions, these competing proposals are still far apart on some issues, particularly the degree of austerity to be imposed upon Greece as indicated by the target primary surplus, that is, the excess of government revenues over expenditures before interest payments, and the absence of any immediate debt relief. Other differences include the creditors’ demands for pension system cuts, higher value-added taxes and labor reforms. Greek Prime Minister Tsipras will find it difficult to sell such a package to his governing coalition. There is a real prospect that a government crisis could result.
Greece faces debt repayments to the IMF of almost 1.6 billion euros ($1.78 billion) this month and is very unlikely to be able to meet this obligation without a deal being agreed. And in July Greece faces further amortization and interest payments, mainly to the European Central Bank, of 4.8 billion euros, followed by about 3.5 billion euros in August. Note that this debt is largely in official hands.
The costs of failure and a Greek default would be high for Greece and even higher for Europe. This is why most observers, including us, believe it is likely that in the end a deal will be reached that will avoid default and a Greek exit from the euro and the Eurozone. It is likely that the deal will come in stages, with an agreement to deal first with the June debt repayments, followed by negotiations extending into July on a more comprehensive bailout package that may also include some debt relief.
The risk of an “accident” has clearly increased. Moreover, longer term, if the conditions imposed on Greece do not provide scope for the Greek economy to recover, the problem will just have been kicked down the road for Europe. Indeed, this appears likely. With Greece having some 320 billion euros of sovereign debt to service and its small economy being severely depressed, the “final act” for Greece will require Europe to eventually recognize the necessity of significant debt relief.
The Eurozone economy is continuing to improve in the second quarter despite some weakness in Germany. The final composite Purchasing Managers Index for May, while slightly below the April reading, indicates a continuing advance. GDP growth could be close to 2% this year, much better than last year’s paltry 0.9% growth. Prospects are good for strong earnings growth this year. The 12-month forward consensus P/E for Stoxx Europe 600, at 16.2, is beginning to look stretched; but with the very low bond yields, the equity risk premium of over 7% indicates that valuations are still attractive.
In anticipation that a bailout deal covering the next several months will eventually be achieved, Cumberland Advisors’ International and Global Equity ETF Portfolios remain overweight for the Eurozone. While we expect that a positive outcome of the negotiations would likely give an upward bounce to the euro, the euro’s decline versus the US dollar would be expected to resume in the second half of the year and beyond due to the continuing fundamental factors of divergent monetary policies and relatively stronger economic growth in the US.
We are thus continuing to use ETFs that are hedged against changes in the euro-US dollar exchange rate. We are using the WisdomTree Europe Hedged Equity Fund (NYSEARCA:HEDJ), which is up 16.8% year-to-date as of June 3. Without the currency hedge, the return to US-dollar-based investors would have been about 8 percentage points less.
We will be monitoring the situation in Europe closely and be ready to adjust our positions quickly if necessary. A greater prospect of a “Grexit,” while probably not of major, lasting importance to the Eurozone economy, would surprise and disturb financial markets, causing equities to retreat.