Tuesday, April 21st, 2015

One Minute to Midnight

The next two Greek bank holidays fall on a Friday and a Monday – May 1st and June 1st. The Government therefore has two ready-made long weekends in the next six weeks, on which it could announce that it is defaulting on its obligations and leaving the Eurozone. We are not in the prediction business, so it is not our job to work out what is going to happen, though it is clear that the current situation cannot continue for much longer. Our aim is to understand what the markets are telling us and to make sure our clients are aware of the risks they are running. Here are some conclusions drawn from a variety of different models.

  1. Greece is already cut-off from European capital markets. Our sovereign bond model recommends a 100% underweight on Greek 10-year bonds vs the rest of the Eurozone. Our equity model has a 97% underweight. This situation has been in place for almost three months, so we agree with the consensus that the first-order contagion effects of Grexit would be limited.
  2. Investors who regard Greek equities as a screaming buy after Grexit need to be aware that Greece also ranks flat-last in our ranking of 44 emerging and developed equity markets. So it’s not just Europe that the country has a problem with. We are concerned that it may take many months before the trading and settlement infrastructure was sufficiently robust to allow institutional investors to invest again. This would be more like Argentina in 2001, than the UK in 1992.
  3. Contagion comes in many forms. Even without a wave of bankruptcies, there would be significant volatility across European financial markets. Our Eurozone bond model suggests that Spain would be the worst affected. In the last three weeks, the recommended weight has gone from +30% to -6% relative to benchmark, and it has fallen from #4 to #7 in the ranking. Italy #3 is also a problem but not on the same scale (overweight cut from +45% to +36%). Interestingly Portugal #2 has hardly been affected (overweight +77% to +76%):
  4. Our Eurozone equity model has a completely different ranking with the Benelux and Germany at the top. Investors seem to believe that the initial default would not compromise their financial sectors and that the resulting stimulus from the ECB would make their export sectors hyper-competitive. Spain #9 and Portugal #10 are at the bottom – in contrast to their position near the top of the bond table- implying these countries would remain in the Eurozone but that the cost of doing so would further damage their growth prospects. Italy has a much bigger export sector than the other two and is #7 in the equity ranking.
  5. Our models offer no clue as to whether the euro would be stronger or weaker six months after Grexit. Either result is possible, but we suspect that that this would be driven more by the behaviour of financial markets and less by the performance of the underlying economies. Investors should be aware that our Eurozone sector model has just cut Financials to underweight from neutral, and it has the lowest weight attached to the Financials sector in any of our regional equity sector models. Enjoy the bank holiday.

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