By Toby Nangle, Global Co-Head of Multi Asset & Head of Asset Allocation, EMEA, and Martin Harvey, Portfolio Manager, Fixed Income, EMEA
Talks between Greece and its creditors collapsed over the weekend. The Greek government has called a referendum on July 5 to accept or reject its creditors' terms - a move almost universally considered to be a poll on the continued membership of the euro area. The timing of this latest turn may have taken many by surprise, but like watching a slow-motion train wreck, few could say they didn't see it coming.
Until two weeks ago, the market had been split as to whether a deal with creditors would get done or capital controls would be imposed and the prospect of a Greek exit or "Grexit" introduced. As the pendulum swung away from capital controls and towards a deal, European stocks jumped 8% and Southern European government bonds rallied versus their Northern European government counterparts. This morning we have seen those moves begin to unwind abruptly, and the prospect of euro-area exit return swiftly to the market calculus.
It is hard to see how uncertainty diminishes in the near term. While a No vote would prevent Greek banks from again accessing ECB liquidity, engraining a de facto exit from the eurozone, (initial) recent polls suggest a majority for a Yes vote against which the current government is campaigning. The closure of Greek banks this week appears to strengthen the likelihood of Greece voting to accept its creditors' terms. But the consequence of a Yes vote is far from clear-cut. The Greek government would be committed to accepting and implementing a program to which it objects.
Some commentators have suggested that the governing political party - SYRIZA - would call an immediate election rather than implement the program, but it is far from clear that this would occur.
How likely is the Greek crisis to affect other European markets?
In fixed income, we believe that the risk of contagion in Europe is underpriced. In a "disorderly exit" scenario, we feel that Italian spreads should trade wider than 200 basis points versus German bunds as a greater risk premium is required. Over the medium term, peripheral bonds should remain supported by, above all, the ECB, thus preventing a return to spread levels reached in 2012.
What about the euro? What is the outlook from here?
Over the medium term, we expect the euro to depreciate due to monetary policy divergence. A Grexit scenario should in our view be negative for the euro as the fundamental viability of the monetary union is called into question. However, the reaction of the euro to recent turbulence has been somewhat unpredictable recently, at times appreciating on bad news.
Are you concerned about the lack of liquidity in bond markets?
Bond market liquidity is a wider concern not specific to the Greek episode. Liquidity in core bond markets such as German bunds has been poor in recent months, leading to rising volatility, and added uncertainty emanating from Greece is unlikely to help the situation. The government bond market has seen the most noticeable deterioration in liquidity in recent months, which has garnered attention given that it is generally the most liquid corner of financial markets.
What is the outlook for European earnings?
We are still forecasting a strong earnings outlook for European companies. But we are far from alone in this view, and the valuation picture for European equities looks uncompelling absent the delivery of this strong earnings outlook.
The European earnings outlook does not look immediately compromised by events in Greece, although this will depend upon the impact on consumer and business confidence and the credit channel remaining open for creditworthy borrowers in Southern Europe.
So far, we have little evidence to suggest that depositor confidence in other European countries is dented or that credit conditions have immediately deteriorated, and so our positive outlook for European fundamentals is unchallenged. But the certainty with which we attach to this positive picture has diminished at the margin, and so the price we are willing to pay has reduced.
Can the ECB ring-fence Greece and prevent blowback into the European banking system?
The ECB appears to be happy with verbal intervention. Quantitative easing (QE) is one short-term fix - the ECB could bring its QE program forward, and increase the size of its purchases - but that is only likely if the ECB's inflation target is in jeopardy. That does not appear to be likely at current levels.
Will the spillover be contained at public/institutional rather than private level?
About 12% of Greek debt is held privately. The banks do hold some Greek T-bills, but the vast majority of the debt is held by institutions. Even before today, few market participants are likely to have perceived Greek assets as risk-free. Crises often develop around surprises, such as when what was once a risk-free asset is no longer perceived as risk free. Remember that everyone has known for a long time that Greece's day of reckoning was approaching. While the timing of that reckoning may be surprising, the reckoning itself should not be.
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