June 8, 2018 by In the long run

Italy and the repricing of European government debt

Macro Letter – No 98 – 08-06-2018

Italy and the repricing of European government debt

The yield spread between 10yr BTPs and Bunds widened 114bp in May
Populist and anti-EU politics were the catalyst for this repricing of risk
Spain, Portugal and Greece all saw yields increase as Bund yields declined
The ECB policy of OMT should help to avoid a repeat of 2011/2012

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets. I will freely admit that this has led me to make a number of investment mistakes, although these have generally been sins of omission rather than actual investment losses. The Italian political situation and the sharp rise in Italian bond yields it precipitated, last week, is, therefore, some justification for an investor like myself, one who has not held any fixed income securities since 2010.

An excellent overview of the Italian political situation is contained in the latest essay from John Mauldin of Mauldin Economics – From the Front Line – The Italian Trigger:-

Italy had been without a government since its March 4 election, which yielded a hung parliament with no party or coalition holding a majority. The Five Star Movement and Lega Nord finally reached a deal, to most everyone’s surprise since those two parties, while both broadly populist, have some big differences. Nonetheless, they found enough common ground to propose a cabinet to President Sergio Mattarella.

Italian presidents are generally seen as rubberstamp figureheads. They really aren’t supposed to insert themselves into the process. Yet Mattarella unexpectedly rejected the coalition’s proposed finance minister, 81-year-old economist Paolo Savona, on the grounds Savona had previously opposed Italy’s eurozone membership. This enraged Five Star and Lega Nord, who then ended their plans to form a government and threatened to impeach Mattarella.

The whole article is well worth reading and goes on to look at debt from a global perspective. John anticipates what he calls, ‘The Great Reset,’ when the reckoning for the excessive levels of debt arrives.

Returning to the repricing of Eurozone (EZ) debt last month, those readers who have followed my market commentaries since the 1990’s, might recall an article I penned about the convergence of European government bond yields in the period preceding the introduction of the Euro. At that juncture (1998) excepting Greece, every bond market, whose government was about to adopt the Euro, was trading at a narrower credit spread to 10yr German bunds than the yield differential between the highest and lowest credit in the US municipal bond market. The widest differential in the muni-market at that time was 110bp. It was between Alabama and California – remember this was prior to the bursting of the Tech bubble.

In my article I warned about the risk of a significant repricing of European credit spreads once the honeymoon period of the single currency had ended. I had to wait more than a decade, but in 2010/2011 it looked as if I might be vindicated – this column is not entitled In the Long Run without just cause – then what one might dub the Madness of Crowds of Central Bankers intervened, saved the EZ and consigned my cautionary oracles, on the perils of the quest for yield, to the dustbin of history.

In the intervening period, since 2011, I have watched European yields inexorably converge and absolute yields turn negative, in several EZ countries, with a temerity which smacks of permanence. I have also arrived at a new conclusion about the limits of credit risk within a currency union: that they are governed by fiat in much the same manner as currencies. As long as the market believes that Mr Draghi will do, ‘…whatever it takes,’ investors will be enticed by relatively small yield enhancements.

Let me elaborate on this newly-minted theory by way of an example. Back in March 2012, Greek 10yr yields reached 41.77% at that moment German 10yr yields were a mere 2.08%. The risk of contagion was steadily growing, as other peripheral EZ bond markets declined. Greece, in and of itself, was and remains, a small percentage of EZ GDP, but, as Portuguese and Spanish bonds began to follow the lead of Greece, the fear at the ECB – and even at the Bundesbank – was that Italy might succumb to contagion. Due to its size, the Italian bond market, was then, and remains today, the elephant in the room.

During the course of last month, European bond markets diverged. The table below shows the change in 10yr yields between 1^st and 31^st May:-

EZ 10yr yield change May 2018

Source: Investing.com

A certain degree of contagion is evident, although the PIGS have lost an ‘I’ as Irish Gilts have escaped the pejorative acronym.

At the peaks of the previous crisis, Irish 10yr Gilts made a yield high of 14.61% in July 2011, at which point their spread versus 10yr Bunds was 11.34%. When Italy entered her own period of distress, in November of that year, the highest 10yr BTP yield recorded was 7.51% and the spread over Germany reached 5.13%. By the time Greek 10yr yields reached their zenith, in March 2012, German yields were already lower and Irish and Italian spreads had begun to narrow.

During the course of last month the interest rate differential between 10yr Bunds and their Irish, Greek and Italian counterparts widened by 41, 100 and 114bp respectively. Italian 10yr yields closed at 4.25% over Bunds, less than 100bp from their 2011 crisis highs. With absolute yields significantly lower today (German 10yr yields were 2.38% in November 2011 they ended May 2018 at 36bp) the absolute percentage return differential is even higher than during the 2011 period. At 2.72% BTPs offer a return which is 7.5 times greater than 10yr Bunds. Back in 2011 the 7.51% yield was a little over three times the return available from 10yr Bunds.

I am forced to believe the reaction of the BTP market has been excessive and that spreads will narrow during the next few months. If I am incorrect in my expectation, it will fall to Mr Draghi to intervene. The Outright Monetary Transactions – OMT – policy of the ECB allows it to purchase a basket of European government bonds on a GDP weighted basis. If another crisis appears immanent they could adjust this policy to duration weight their purchases. It would then permit them to buy a larger proportion of the higher yielding, higher coupon bonds of the southern periphery. There would, no doubt, be complaints from those countries that practice greater fiscal rectitude, but the policy shift could be justified on investment grounds. If the default risk of all members of the EZ is equal due to the political will of the European Commission, then it makes sense from an investment perspective for the ECB to purchase higher yielding bonds if they have the same credit risk. A new incarnation of the Draghi Put could be implemented without too many objections from Frankfurt.

Conclusions and investment opportunities

I doubt we will see a repeat of the 2011/2012 period. Lightening seldom strikes twice in the same way. The ECB will continue with its QE programme and this will ensure that EZ government bond yields remain at artificially low levels for the foreseeable future.

Unusually, I have an actionable trade idea: caveat emptor! I believe the recent widening of the 10yr Italian BTP/Spanish Bonos spread has been excessive. If there is bond market contagion, as a result of the political situation in Italy, Bonos yields may have difficulty defying gravity. If the Italian political environment should improve, the over-sold BTP market should rebound. If the ECB are forced to act to avert a new EZ crisis by increasing OMT or implementing a duration weighted approach to QE, Italy should benefit more than Spain until the yield differential narrows.

February 16, 2018 by In the long run

A safe place to hide – inflation and the bond markets

Macro Letter – No 91 – 16-02-2018

A safe place to hide – inflation and the bond markets

US bond yields have risen from historic lows, they should rise further, they may not
The Federal Reserve is beginning to reduce its balance sheet other CBs continue QE
US bonds may still be a safe haven but a hawkish Fed makes short duration vulnerable
Short dated UK Gilts make be a safe place to hide, come the correction in stocks

US Bonds

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993

Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.

More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19^th October 1955:-

If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.

Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-

US Inflation and 10yr bond yield 1950 to 1973

Source: Trading Economics

I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.

Central Bank balance sheets

Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-

CB_Balance_Sheets_-_Yardeni

Source: Haver Analytics, Yardeni Research

Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-

US_debt_ownership_Dec_2016

Source: US Treasury

As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.

Bond Markets in Europe and Japan

The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.

Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-

Germany vs Greece 10yr yields

Source: Trading Economics

By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.

Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.

The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.

Conclusions and Investment Opportunities

From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.

As a defensive investment one should look for short duration bonds, but in the US this brings the investor into conflict with the hawkish policy stance of the Fed; that is, what my friend Ben Hunt of Epsilon Theory dubs, the Inflation Narrative. For a contrary view this Kansas City Fed paper may be of interest – Has the Anchoring of Inflation Expectations Changed in the United States during the Past Decade?

In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-

united-kingdom-2-year-note-yield - 5yr

Source: Trading Economics

UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.

With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.

October 13, 2017 by In the long run

European Bonds – warning knell or cause for celebration?

Macro Letter – No 85 – 13-10-2017

European Bonds – warning knell or cause for celebration?

Greek bonds have been the best performer in the Eurozone year to date
IMF austerity is still in place but there are hopes they will relent
Portuguese bonds have also rallied since March whilst Spanish Bonos declined
German Bund yields are up 28bps since January heralding an end to ECB QE

Writing, as government bond yields for peripheral European markets peaked in Macro Letter – No 73 – 24-03-2017 – Can a multi-speed European Union evolve? I felt that another Eurozone crisis could not be ruled out:-

The ECB would almost certainly like to taper its quantitative easing, especially in light of the current tightening by the US. It reduced its monthly purchases from Eur 80bln per month to Eur 60bln in December but financial markets only permitted Mr Draghi to escape unscathed because he extended the duration of the programme from March to December 2017. Further reductions in purchases may cause European government bond spreads to diverge dramatically. Since the beginning of the year 10yr BTPs have moved from 166bp over 10yr German Bunds to 2.11% – this spread has more than doubled since January 2016.

Was I simply wrong or just horribly premature, only time will tell? The December end of the asset purchase programme is growing inexorably closer. So far, however, despite a rise in the popularity of AfD in Germany, the Eurozone seems to have maintained its equanimity. The Euro has not weakened but strengthened, European growth has improved (to +2.3% in Q2) and European stock markets have risen. But, perhaps, the most interesting development has occurred in European bond markets. Even as the Federal Reserve has raised short term interest rates, announcing the beginning of balance sheet reduction, and the ECB has continued to prepare the markets for an end to QE, peripheral bonds in Europe have seen a substantial decline in yields: and their respective spreads against the core German Bund have narrowed even further. Is this a sign of a more cohesive Europe and can the trend continue?

To begin here is a chart of the Greek 10yr and the German 10yr since January, the Bund yield is on the Left Hand Scale and the Greek 10yr Bond on the Right:-

Source: Trading Economics

The table below looks at a selection of peripheral European markets together with the major international bond markets. Switzerland, which has the lowest 10yr yield of all, has been included for good measure. The table is arranged by change in yield:-

Source: Investing.com

This year’s clear winners are Greece and Portugal – the latter was upgraded to ‘investment grade’ by S&P in September. It is interesting to note that despite its low absolute yield Irish Gilts have continued to converge towards Bunds, whilst BTPs and Bonos, which yield considerably more, have been tentatively unnerved by the prospect of an end to ECB largesse.

As an aside, the reluctance of the Bonos to narrow versus BTPs (it closed to 41bp on 4^th October) even in the face of calls for Catalonian independence, appears to indicate a united Spain for some while yet. Don’t shoot the messenger I’m only telling you what the markets are saying; in matters of politics they can be as wrong as anyone.

Where now for European bonds?

A good place to start when attempted to divine where the European bond markets may be heading is by considering the outcome of the German election. Wolfgang Bauer of M&G Bond Vigilantes – Angela Merkel’s Pyrrhic victory – writing at the end of last month, prior to the Catalan vote, takes up the story:-

Populism is back with a vengeance

One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader. While this is certainly noteworthy, to say the least, the direct political implications are likely to be minimal. None of the other parties is going to form a coalition with them and AfD members of parliament are likely to be treated as political pariahs. We have seen this happening in German state parliaments many times before.

However, I think there might be two important indirect consequences of the AfD’s electoral success. First, within Germany the pressure on Merkel, not least from her own party, with regards to policy changes is going to build up. For obvious reasons, preventing the rise of a right-wing nationalist movement has been a central dogma in German politics. That’s out of the window now after the AfD’s double digits score last night – on Merkel’s watch. In the past, she has been willing to revise long-held positions (on nuclear power, the minimum wage, same sex marriage etc.) when she felt that sentiment amongst voters was shifting. In order to prise back votes from the AfD she might change tack again, possibly turning more conservative, with a stricter stance on migration, EU centralisation and so on.

Secondly, the success of the AfD at the ballot box might challenge the prevailing narrative, particularly since the Dutch and French elections, that anti-EU populism is on the decline. This could have implications for markets, which arguably have become somewhat complacent in this regard. The Euro, which has been going from strength to strength in recent months, might get under pressure. Compressed peripheral risk premiums for government and corporate bonds might widen again, considering that there are more political events on the horizon, namely the Catalan independence referendum as well as elections in Austria and Italy.

This sounds remarkably like my letter from March. Was it simply that I got my timing wrong or are we both out of kilter with the markets?

The chart below shows the steady decline in unemployment across Europe:-

Source: BNP Paribas Asset Management, Datastream

The rate of economic expansion in European is increasing and measures of the popularity of the Eurozone look robust. Nathalie Benatia of BNP Paribas – Yes, Europe is indeed back puts it like this:-

…take some time to look at this chart from the European Commission’s latest ‘Standard Eurobarometer’, which was released in July 2017 and is based on field surveys done two months earlier, just after the French presidential election, an event that shook the world (or, at least, the French government bond market). Suffice it to say that citizens of eurozone countries have never been so fond of the single currency.

Source: European Commission, Eurobarometer Spring 2017, Public Opinion in the European Union, BNP Paribas Asset Management

The political headwinds, which I clearly misjudged in March, are in favour of a continued convergence of Eurozone bonds. Italy and Spain offer some yield enhancement but Portugal and Greece, despite a spectacular performance year to date, still offer more value. The table below shows the yield for each market at the end of November 2009 (when European yield convergence was at its recent zenith) and the situation today. The final column shows the differential between the spreads:-

Source: Investing.com

Only Irish Gilts look overpriced on this metric. Personally I do not believe the yield differentials exhibited in 2009 were justified: but the market has been proving me wrong since long before the introduction of the Euro in 1999. Some of you may remember my 1996 article on the difference between US municipal bond yields and pre-Euro government bond yields of those nations joining the Euro. I feared for the German tax payer then – I still do now.

I expect the yield on Bunds to slowly rise as the ECB follows the lead of the Federal Reserve, but this does not mean that higher yielding European bond markets will necessarily follow suit. I continue to look for opportunities to buy Bonos versus BTPs if the approach parity but I feel I have missed the best of the Greek convergence trade for this year. Hopes that the IMF will desist in their demands for continued austerity has buoyed Greek bonds for some while. The majority of this anticipated good news is probably already in the price. If you are long Greek bonds then Irish Gilts might offer a potential hedge against the return of a Eurozone crisis, although the differential in volatility between the two markets will make this an uncomfortable trade in the meanwhile.

Back in March I expected European bond yields to rise and spreads between the periphery and the core to widen, I certainly got that wrong. Now convergence is back in fashion, at least for the smaller markets, but Europe’s political will remains fragile. The party’s in full swing, but don’t be the last to leave.

April 24, 2015 by In the long run

Greece in or out – Investment Opportunities?

Macro Letter – No 34 – 24-04-2015

Greece in or out – Investment Opportunities?

Greece needs to reschedule its debt or default
Capital Controls maybe inevitable
A piecemeal solution is not the answer, yet it’s more likely than a “Lehman moment”
A definitive solution presents investment opportunities

Earlier this week I paid a visit to the Greek Island of Corfu. Whilst most of what we read and observe about the Greek economy revolves around Athens, I thought it would be useful to gain a broader perspective on the state of the economy. I wanted to consider, what things might be like, if Greece stays within the Eurozone (EZ) or, conversely, if they decide to leave.

Firstly a few Greek economic facts:-

Top of FormMarketsBottom of Form	Last	Date	Frequency
GDP Annual Growth Rate	1.2%	Nov-14	Quarterly
GDP per capita	18146 USD	Dec-13	Yearly
Unemployment Rate	25.7%	Jan-15	Monthly
Youth Unemployment Rate	51.2%	Dec-14	Monthly
Population	10.99mln	Dec-14	Yearly
Minimum Wages	684	Dec-14	Monthly
Inflation Rate	-2.1%	Mar-15	Monthly
Core Inflation Rate	-1.2%	Jan-15	Monthly
Producer Prices Change	-4.8%	Feb-15	Monthly
Balance of Trade	-1,425mln	Feb-15	Monthly
Exports	2,024mln	Feb-15	Monthly
Imports	3,449mln	Feb-15	Monthly
Current Account	-850mln	Jan-15	Monthly
Government Debt to GDP	175%	Dec-13	Yearly
Government Spending to GDP	59.2%	Dec-13	Yearly
Business Confidence	96.8	Mar-15	Monthly
Manufacturing PMI	48.9	Mar-15	Monthly
Industrial Production	1.9%	Feb-15	Monthly
Manufacturing Production	5.8%	Feb-15	Monthly
Capacity Utilization	65.7%	Feb-15	Monthly
Industrial Production Mom	-4.7%	Jan-15	Monthly
Consumer Confidence	-31	Mar-15	Monthly
Retail Sales YoY	-0.1%	Jan-15	Monthly
Housing Index	-22%	Feb-15	Monthly
Corporate Tax Rate	26%	Jan-14	Yearly
Personal Income Tax Rate	46%	Jan-14	Yearly
Sales Tax Rate	23%	Jan-14	Yearly

Source: Trading Economics

Eurostat published their European Winter Economic forecasts 5^th February – this is an extract from their, ever so rosy, forecast for Greece:-

Indicator	2013	2014	2015	2016
GDP growth (yoy)	-3,9%	1,0%	2,5%	3,6%
Inflation (yoy)	-0,9%	-1,4%	-0,3%	0,7%
Unemployment	27,5%	26,6%	25,0%	22,0%
Public budget balance to GDP	-12,2%	-2,5%	1,1%	1,6%
Gross public debt to GDP	174,9%	176,3%	170,2%	159,2%
Current account balance to GDP	-2,3%	-2,0%	-1,5%	-0,9%

Source: Eurostat

According to information collated from the CIA Factbook , OECD and Eurostat, the Greek public sector still accounts for 40% of GDP. The largest industry is Tourism (18%) followed by Shipping – the Hellenic Merchant Marine is the largest in the world employing 160,000 (4% of the workforce). The Greek shipping fleet is the fourth largest in the world, representing 15.17% of global deadweight tonnage in 2013, although “flag of convenience” issues can make these figures a little misleading. The labour force is estimated at 3.91mln of which immigrants account for 782,000 (20%). This makes Greece the 8^th largest immigrant population in Europe – mainly unskilled or agricultural workers. As a result of the economic crisis private saving has increased from 11.2% in 2012 to 14.5% in 2014.

The largest broad industry sector is Services (which includes Tourism) accounting for 80.6% of GDP and 72.4% of employment, followed by Industry – 15.9% of GDP and 14.7% of employment. Agriculture is third in size producing 3.5% of GDP but employing 12.9% of the population.

Greece’s largest export market is Turkey (11.6%) and its largest import partner is Russia (14.1%). Little wonder they wish to maintain good relations with Moscow.

In terms of Tourism, Greece is the 7^th most visited country in Europe and the 16^th most visited globally. The latest figure I could unearth, from a 2008 OECD report, indicated 840,000 workers employed in the sector, from which I estimate that Tourism accounts for more than 20% of employment.

A more detailed analysis of the island economies of Greece came from a paper published by Sheffield University – A Comparative Analysis of the Economic Performance of Greek and British Small Islands – 2006. They analysed 63 islands with an average population of around 300,000. Employment was at 88.81% whilst Unemployed was a mere 11.19% – this was around the average for the whole country at that time. To my surprise, the level of reported self-employment was a relatively low 20.43%. One of the more puzzling figures was for Home Occupancy 46.05%; the Greek average for Home Ownership is 75.8% (2013). Unsurprisingly the main industry is Tourism followed by agriculture – it’s worth pointing out that Greece is the EU’s largest producer of Cotton, second largest producer of Rice and Olives, third largest producer of Tomatoes and fourth largest producer of Tobacco. It also accounts for 19% of all fish hauled from the Mediterranean, making it the third largest in the EU as of 2007 data.

The table below shows the regional breakdown of GDP by region for 2010:-

Region	GDP Euro	GDP %	GDP Growth
Attica	106,635	48	-3.51
Northern Greece	55,163	24.83	-4.73
Central Greece	38,767	17.45	-3.03
Central Macedonia	30,087	13.54	-5.19
Aegean Islands and Crete	21,586	9.72	-4.84
Crete	10,955	4.93	-3.79
Thessaly	10,742	4.84	-6.55
West Greece	10,326	4.65	-2.9
Sterea Hellas	10,059	4.53	-1.25
Peloponnese	9,436	4.25	-3.97
East Macedonia and Thrace	9,054	4.08	-1.69
South Aegean	7,476	3.37	-5.4
West Macedonia	5,281	2.38	-3.3
Epirus	4,917	2.21	-2.36
Ionian Islands	4,029	1.81	-6.22
North Aegean	3,155	1.42	-7.04

Source: Eurostat

The islands are very much the “poor relation” in terms of economic output but, as the map below, from 2008, shows, the GDP per capita distribution is more dispersed:-

Source: Eurostat

I visited Corfu, the second largest island in the Ionian Sea, with a population of just over 100,000. Its main business is Tourism followed by the production of olives. Back in 2013 NCH Capital – a US investment firm, best known for their investments in agriculture in the Ukraine and Russia, agreed a deal with the Hellenic Republic Development Fund (HRDF) to build a tourist resort on the island. This was the first time the Greek state had sold land to a foreign investor for 15 years. The HRDF has been charged with raising Euro 11bln from asset sales by 2016 – this represents a small fraction of the assets available should the Hellenic Republic decide to cut and run.

The NCH investment is not moving forward as swiftly as they had hoped, as this article from Tax Law explains. It is worth pointing out that Corfu is located at the North West corner of Greece, its North East coast looking across the narrow straits to Albania; little wonder there is some concern about the reduction of a naval presence in the region. However, Albania became a full member of NATO in 2009. Since 2010 Albanians have been able to enter the EU without visas and, as of June 2014, they are officially a candidate to join the EU. As a result of these changes, property development is growing along with tourism. Prices for Albanian property are significantly lower than in neighbouring Montenegro, which in turn offer better value than Greece. Regardless of the fortunes of Albania, the prospects for a significant acceleration of Greek state asset disposals is likely, whether Greece leaves or remains within the EZ.

The residential Real Estate market is still depressed by the economic and political uncertainties of the last few years, but, from a rental perspective, tourists keep returning. The price of dining in restaurants is beginning to look attractive in comparison with other Southern European destinations; perhaps more importantly, the differential with prices in Turkey has narrowed. The cost of more expensive holiday homes in Greece is now comparable with those in Spain or Portugal – it used to command around a 40% premium due to planning restrictions. In 2013 the island of Skorpios sold to a Russian buyer for Eur100mln and the island of Oxia was purchased by a member of the Qatari Royal family for Eur 4.9mln, however, worries about a “Lehman moment” – by which I mean Grexit – have dampened enthusiasm for a number of subsequent deals.

If Greece leaves the EZ and the new currency promptly depreciates, there will still be a number of uncertainties. To begin with, the Greek government is likely to impose capital controls to prevent capital flight – Greek Prime Minister Alexis Tsipras has started the process, instructing local governments to move their funds to the central bank earlier this week. For non-domicile property owners, these controls could mean they are unable to repatriate the proceeds of sales. I was interested to notice how many restaurants no longer accept credit card payment; would you put the proceeds of a property sale into a Greek bank whilst waiting for capital controls to be relaxed?

Another factor which may delay a recovery in Real Estate is the reaction of non-EU nationals who have bought Greek property for more than Eur250,000, in order to gain EU status – a scheme also available in Portugal. This Greek Law Digest article explains.

Selling pressure on property prices will continue to come from Greek domestic investors downsizing of their rental portfolios. During the first few years of EZ membership, many Greeks bought multiple holiday rentals. Since the crisis, maintenance costs have soared as a result of the “haratsi” property tax. Meanwhile, the financial police are aggressively pursuing owners who fail to declare rental income. If Greece exits the EU, I would expect Real Estate supply to hang over the market for some while.

A perusal of the windows of Corfu Real Estate agents, whilst far from scientific, suggests that the price of holiday homes is still relatively high. The properties are normally foreign owned and, for the most part, the owners are not distressed sellers. I was struck, however, by the magnitude of the price reductions (up to 80%) on those properties which had “sold”. It feels like a market with low turnover where price discovery is intermittent at best. For the Greek market nationally residential property appraisals-transactions for 2014 were down 33.20% on 2013, dwelling permits fell by 19.3% between January to November 2014 compared to 2013 and total new floor space declined 13.9% y/y to November 2014. The chart below shows that the pace of decline has moderated in the last year but prices are still falling:-

Source: Bank of Greece

The absolute level of the property index suggests that almost all the gains seen in Real Estate prices since joining the EZ have been reversed, but the economy is still not competitive due to the strait-jacket of the Euro:-

Source: Bank of Greece

This article from The Guardian – Home ownership in Greece ‘a sick joke’ as property market collapses from February 2014, attempts to impart a flavour of the overall market, but, as any home owner knows, all property investment is local.

The year so far

To understand the Greek situation you need to go back to the eve of the introduction of the Euro, in 2000, but for a brief overview of the current crisis this excellent video from the Peterson Institute – Greece: An Economic Tragedy in Six Charts is well worth taking five minutes to peruse. Instead, I want to look at the last few months and consider the implications going forward.

As the Greek government begin further negotiations with EZ Finance Ministers today, in an attempt to reschedule their outstanding debt and interest rate payments, it is becoming clearer, to politicians in Brussels, that the “Greek Problem” will not be resolved by wishful thinking and continued austerity. Since January a new scene in this Greek tragedy has begun to unfold.

At the beginning of January Bruegal – Why Grexit would not help Greece – rebutted many commentators, but specifically the German IFO Institute’s call for Greece to leave the EZ. Bruegal focussed on the unique aspects of the Greek situation, pointing out that, unlike Portugal, Ireland and Spain, Greek imports had collapsed but their exports had only recently started to improve:-

Are high wages the main problem in Greece hampering exports? Is the absence of a real depreciation the main driver of the different adjustment experience of Greece compared to the other euro area countries?

…hourly wages have come down substantially in Greece and are in fact the lowest in the euro area with the exception of Latvia and Lithuania. This contrasts with the experience in the other three countries adjusting, where hourly wages in the private sector have increased.

Source: Eurostat

Overall, I conclude that the Greek economy would not benefit as much as hoped for from a rapid depreciation. The reasons for the weak Greek export performance might primarily lie in other factors such as rigid product markets, a political system preventing real change and guaranteeing the benefits of the few, the lack of meritocracy among other factors…

This does not mean that the current debt trajectory and debt level is sustainable. It may be necessary to further alleviate the debt burden on Greece, especially if inflation remains low and growth is weaker than the Troika believes. This has been done a number of times before by the official creditors and already now the average maturity on the European debt is 30 years. This maturity could be increased if necessary, effectively reducing the debt burden further and I could even see a nominal debt cut at some stage.

Later in January Bruegal – How to reduce the Greek debt burden? Looked at the options available to Greece and her creditors:-

Option 1: Reducing the lending rate on the Greek Loan Facility

Option 2: Extending the maturity of the loans in the Greek Loan Facility

Option 3: Extending maturity of EFSF loans

Option 4: Buying-back the Greek government bond holdings of the ECB and National Central Banks

Option 5: Swapping the currently floating interest rate loans to fixed rate loans

Option 6: Swapping the current loans to GDP-indexed loans

Option 7: Pre-privatisation using European funds

The tone of quasi-official commentary changed in February, when the ECB ceased to accept Greek government bonds as collateral for normal refinancing operations. Bruegal – The Greek banking system: a tragedy in the making? finally acknowledged the ECBs obligation to “lend freely” but only “against good collateral”:-

One can criticize the ECB’s decision for aggravating the crisis but one can also argue that the ECB had no choice but to act as it did given the self-proclaimed insolvency of the Greek state.

Greek Finance Minister – Yanis Varoufakis – announced their new plan shortly after Syriza won the election. The FT – Greece finance minister reveals plan to end debt stand-off – 2^nd February described it as:-

Attempting to sound an emollient note, Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

…“What I’ll say to our partners is that we are putting together a combination of a primary budget surplus and a reform agenda,”

…“I’ll say, ‘Help us to reform our country and give us some fiscal space to do this, otherwise we shall continue to suffocate and become a deformed rather than a reformed Greece’.”

After talks broke down later in February Bruegal – Europe needs a lasting solution for the Greek problem wrote:-

I expect that fear of Grexit will prompt an agreement between Greece and euro-area partners. But my concern is that the agreement will be only a short-term fix and the various constraints will prevent reaching a lasting solution, thereby just postponing the problems. That would be the next stage in the Greek tragedy, as debt sustainability problems would likely return in a few years.

The following two tables show the payment flashpoints on the Greek road to redemption:-

Source: Datastream

Source: IMF

Early March saw the publication of the Greek State Budget Execution Monthly Bulletin – the primary balance was only slightly below forecast, but closer inspection revealed that the majority of the improvement in the primary balance has been achieved by reducing expenditures. Revenues were Eur 7.8bln – around Eur 1bln below target. Without the benefit of currency devaluation, the broader Greek economy is still struggling to adjust.

A Closer look at the chances for a Greek recovery

The Greek government debt burden is unsustainable, in 2013 its Debt to GDP ratio was 174.9. According to Nationaldebtclocks.org the current figure is Eur 354bln. Greek 2014 GDP was $246bln (Eur189) and GDP for 2015 is estimated to be +0.7% (Eur 190bln) I assume a EURUSD 1.30 exchange rate so, perhaps, I’m painting an overly bleak picture. Official estimates put Greek government indebtedness at nearer to Eur 228bln.

Assume Greece manages to run a primary surplus of 3% in perpetuity – that equates to around Eur 5bln per annum. Assume they manage to negotiate zero interest on all their outstanding debt. It would take 70 years to repay – and 35 years to bring it back below 100% of current GDP. You may argue that 1. National Debt is the wrong measure, since Government Debt is the issue, but, if Greece leaves the EZ, creditors will need to consider all her obligations. 2. That it is unrealistic to assume no growth in GDP, but Greek GDP growth averaged 0.97% from 1996 to 2014, reaching an all-time high of 7.50% in the fourth quarter of 2003. It crashed to -9.9% in Q1 2011. Meanwhile Greek Inflation averaged 8.94% between 1960 and 2015. Recently deflation has set in, with prices falling to a record low of -2.90% in November of 2013.

These numbers don’t add up; either the creditor nations and institutions embrace substantial rescheduling and debt forgiveness, or Greece defaults, exits the EZ, devalues and potentially precipitates an EZ wide financial crisis. In PWC – Global Economy Watch – What would a Greek exit mean for the Eurozone? The authors estimate the impact of a Grexit on the rest of the EZ, Germany’s banking sector is most exposed (Eur29.5bln) although this still only amounts to 0.8% of GDP:-

Banking sector – Our analysis suggests that the Eurozone banking sector should be able to manage the impact of a Greek exit without severe consequences. The exposure of banks in the four largest Eurozone economies (Germany, France, Italy and Spain) to Greece has fallen from around $104bn in 2010 to $34bn. While the German banking system is the most exposed to Greece, this exposure equates to only around 0.8% of its GDP. For the other economies, France, Italy and Spain, the direct exposure of their banks to Greece is less than 0.1% of GDP.

Greek debt holders – around 60% of Greek government debt is held indirectly by Eurozone governments. If the Greek government defaults on its obligations, then that debt will be written off (at least in part). This could pose a risk to countries which already have a relatively large public debt burden. For example, a Greek exit could have negative implications for Italy, which guarantees around 20% of the Eurozone’s bailout funds, and has a ratio of gross government debt to GDP of around130%. Italy’s exposure to Greek government debt is equivalent to around 2% of its GDP meaning a default could lead to a fiscal squeeze in Italy as the government attempts to fill the hole left in its finances.

Unexpected contagion – A Greek exit could also have effects outside the realm of economic data and financial statistics. It would likely add to political uncertainty as other countries may push for concessions on their commitments or it could set a precedent that sees other countries leave the Eurozone. For example, Spain and Portugal are both experiencing double digit unemployment rates and must hold general elections by the end of 2015. While the domestic consequences of Greece leaving the Eurozone could deter voters in other countries from seeking to leave the single currency area, there remains a possibility of surprising developments occurring in the Eurozone. In addition to this, a Greek exit could also call Greece’s role in the European Union and NATO in to question, spurring even more uncertainty.

Of course, the largest creditors are EZ institutions, led by the ECB which holds Eur 104bln – 65% of Greek GDP, according to Governor Draghi.

By the end of March rumours were starting to circulate of Brussels preparing to impose capital controls in the event of the Greek government running out of money. The Peterson Institute – Can Greece Make a Deal with Europe? – suggests a cut-off, but it’s still some way off:-

When Must a Deal Be Struck?

At the very latest, June/July 2015 would seem to be the deadline. At that point, Greece faces about €6.5 billion in euro bond repayments to the ECB, which it will not have the cash to honor without a new arrangement. A default against the ECB would end all liquidity provisions to Greek banks, including emergency liquidity assistance (ELA) from the Greek central bank. A quick economic death spiral would ensue.

According to an article this week the New York Times – European Central Bank Squeezes Greek Banks, Tightening Access to Loans the Greek banks have resorted to issuing bonds to themselves in order to access the ECBs ELA facility: –

For more than three months, Greece’s largest banks have been forced to borrow short-term, higher-interest money from their central bank — a process called emergency liquidity assistance — because the E.C.B. deemed it too risky to extend credit to the banks itself.

The banks, in turn, have to provide adequate collateral to obtain these loans, which now stand at 74 billion euros, $79.7 billion, or more than half the amount of Greek domestic deposits.

…Controversially, Greek banks have even begun to issue bonds to themselves and, after securing a government guarantee, have used the securities to secure short-term financing…

…On April 8, for example, the National Bank of Greece self-issued €4.1 billion of six-month bonds that carried state backing.

Inevitable “Lehman”?

A number of commentators have been predicting a Greek exit for several years. This was the view expressed in February by David Stockman – History In The Balance: Why Greece Must Repudiate Its ‘Banker Bailout’ Debts And Exit The Euro:–

The true evil started with the bailouts themselves and the resulting usurpation by the EU politicians and apparatchiks of both financial market price discovery and discipline and sovereign democratic prerogatives. Accordingly, the terms of Greece’s current servitude can’t be tweaked, “restructured” or “swapped” within the Brussels bailout framework.

Instead, Varoufakis must firmly brace his interlocutors on the true history and the condition precedent that stands before them. Namely, that the Greek state was effectively bankrupt even before the 2010 bailout, and that the massive amounts of debt piled upon it thereafter was essentially a fraudulent conveyance by the EU.

Accordingly, Greece’s legitimate debt is perhaps $175 billion based on the pre-crisis euro debt outstanding at today’s exchange rate and the haircut that would have occurred in bankruptcy. Greece’s new government has every right to repudiate the vast amount beyond that because it arose not from the actions of the Greek people, but from the treachery of EU politicians and the Troika apparatchiks—-along with the unfaithful stooges in the Greek parliament and ministries which executed their fraudulent conveyance.

The Peterson Institute – Greece Should Ponder the Benefits of Devaluation – presents a couple of novel alternatives:-

There are two other mechanisms through which devaluation could occur, but both are more painful and less efficient than the currency (so called external) devaluation. One way is to simply reduce wages, thus achieving lower prices of domestically-produced goods and making them cheaper abroad. This is easier said than done. Wages are notoriously sticky, and even the wage cuts that Greece accepted have already brought protesters to the streets. Greece reduced wages of public-sector workers in 2010 and again in 2012 and endured months-long strikes. The new Syriza government has just started to undo these measures, with pledges to increase wages to precrisis levels.

The other mechanism to achieve internal devaluation is through tax policy—by reducing taxes on labor and increasing consumption taxes. Reducing taxes serves to reduce the overall cost of labor and hence production. It also encourages firms to look for other markets, as higher consumption prices at home reduce demand. Several European countries tried this, including Italy under Prime Minister Mario Monti in 2012—with some success.

I remember discussing a “devaluation and re-joining” concept, with a hedge fund manager friend of mine back in 2010. “How would it work in practice, and what would happen to the bond holders?” were his perfectly valid responses. From the current vantage, five years on, that 20% devaluation would have been a small price for the bond holders to pay. Meanwhile Greek bank accounts are being siphoned of deposits as the crisis deepens, these charts from an article published by CFR -Greece—a Destabilizing Financial Squeeze – tell an alarming tale:-

Source: Goldman Sachs

It’s amazing that household deposits remain so high, but, with the majority of the Greek people wishing to remain in the Euro, perhaps this is logical.

The chart below shows the breakdown of the balance sheet of the Deutsche Bundesbank:-

Source: Soberlook.com

TARGET2 claims represent around 70% of the total – this is the loans of peripheral EZ national central banks. If “Grexit” leads to “Contagion” this half-trillion Euro accounting entry will start to crystallise – the hole in the Bundesbank balance sheet will have to be footed by the German tax payer.

Personally I still favour an EZ solution. Towards the end of February Michael Pettis – When do we decide that Europe must restructure much of its debt? Took up the theme, reminding us of the, less quoted, preamble to Mario Draghi’s “whatever it takes” speech:-

And this is clearly not just about Greece. Everyone understands that Greece has already restructured its debt once before and received partial forgiveness — in fact once coupon reductions are correctly accounted for Greece’s debt ratio is probably much lower than the roughly 180% of GDP the official numbers suggest. Most people also understand that the Greek debate is not just about Greece but also about whether or not several other countries — Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.

What few people realize, however, is these countries have effectively already done so once. This happened two and a half years ago at the Global Investment Conference in London when, on July 26, 2012, Mario Draghi, President of the European Central Bank, made the following statement:

“When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro. And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

“But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Pettis puts the case for a Europe-wide debt resolution. He quotes from McKinsey – Debt and (not to much) deleveraging – but since “a picture paints a thousand words”:-

Source: Haver Analytics, McKinsey

As Pettis sees it, this is most certainly not about Greece in isolation:-

For now I would argue that the biggest constraint to the EU’s survival is debt. Economists are notoriously inept at understanding how balance sheets function in a dynamic system, and it is precisely for this reason that we haven’t put the resolution of the European debt crisis at the center of the debate. But Europe will not grow, the reforms will not “work”, and unemployment will not drop until the costs of the excessive debt burdens are addressed.

Conclusions and investment opportunities

The yield on Greek 10yr government bonds has begun to rise again (see the monthly chart below) following the dramatic rise in shorter maturities – 2yr yields were at 28% on the open yesterday versus 10yr at 12.7%. This is a clear trend breakout but could be swiftly reversed by an EZ resolution of the current impasse:-

Source: Trading Economics

During the last year Greek stocks have trended lower losing more than 45% since the spring of 2014, yet they are still higher than during the teeth of the last storm that battered the EZ in 2012 when the index plumbed the depths of 471:-

Source: Yahoo Finance

Perhaps of greater relevance, in light of the potential failure of the Greek banking system, is the Greek Bank Index. This, six month chart, highlights the degree to which the economy is being constrained by the spectre of bank defaults:-

Source: Yahoo Finance

The Greece will either remain mired in the morass of debt, successfully restructure or exit the Euro and default on its obligations. In the first scenario bonds will be rescheduled piecemeal but yields should return to single digits in 10yr maturities, reflecting the continued deflation risk associated with the over-hang of debt, the stock market will under-perform due to continued uncertainty and lack of investment but is unlikely to make fresh lows given the steady improvement in growth prospects for the rest of the EZ. Real Estate will continue to trend lower since the only buyers are likely to be domestic firms or individuals – the substantial inventory of domestic sellers will take a considerable time to clear, whilst net outward migration will increase the supply of Real Estate further. This chart shows the net changes in population since 1980:-

Source: The Economist, Eurostat

In the second scenario, bond yields will trade in a range between high single digits and mid-teens, trading in a broadly similar way to scenario one, though, with less deflation risk, the yields are likely to be structurally higher. The stock market will clear and investment will return. House prices will recover as foreign buyers return and ex-patriot workers come home. Scenario three is the most cathartic. Bond yields will rise dramatically since there will no longer be a strong central bank and few businesses or institutions will be organised to exchange the replacement currency. The new currency will devalue and remain volatile, deterring investors from rushing to invest – once the currency stabilises, bond and equity markets will follow suit. High yield investors will be ready to invest in bonds, equity investors will look for businesses with comparative advantages due to their proximity to, and established trading links with, the EZ. Property will also gradually recover, especially in tourist destinations where “holiday homes” will suddenly become even more affordable for many EZ investors.

As I mentioned already, I think scenario two is most likely (45%) though we may have to wait until the “eleventh hour” to see it come to pass. Sadly scenario one is also quite likely (35%) since the EZ political apparatus seems incapable of addressing tough decisions head-on. This still leaves a 20% chance of a “Lehman moment”.

Prospects for the islands

As the paper from Sheffield University explains, island economies are relatively insulated from the external ebb and flow of the wider economy. Proximity to Athens is clearly a factor, but the performance of Crete is a typical example of the localised nature of these economic units. Corfu is only 30 miles from the heel of Italy and its Venetian architecture is testament to these links. The islands are most reliant on Tourism and, despite the crisis and the rioting in Athens, tourists keep coming back to these beautiful, welcoming islands. Not unlike Greece’s second industry – Shipping – Tourism is an international business; it is not held hostage to the fortunes of the hapless Greek political elite.

January 9, 2015 by In the long run

Greece, Germany and the ECB: and what it means for Bonds, Stocks and the Euro

Macro Letter – No 27 – 9-1-2015

Greece, Germany and the ECB and what it means for Bonds, Stocks and the Euro

Greek elections this month have rekindled concern about the future of the Euro

Germany is beginning to consider the ramifications of a Greek exit from the EMU

European bonds – excluding Greece – continue to rise as EUR/USD falls

The ECB needs to make good on its promise to do “whatever it takes”

Greece is back in the spotlight amid renewed fears of a break-up of the Euro as the Syriza party show a 3.1% lead over the incumbent New Democracy in the latest Rass opinion poll – 4^th January. The average of the last 20 polls – dating back to 15^th December shows Syriza with a lead of 4.74% capturing 31.9% of the vote.

These election concerns have become elevated since the publication of an article in Der Spiegel Grexit Grumblings: Germany Open to Possible Greek Euro Zone Exit -suggesting that German Chancellor Merkel is now of the opinion that the Eurozone (EZ) can survive without Greece. Whilst Steffen Seibert – Merkle’s press spokesman – has since stated that the “political leadership” isn’t working on blueprints for a Greek exit, the idea that Greece might be “let go” has captured the imagination of the markets.

A very different view, of the potential damage a Greek exit might cause to the EZ, is expressed by Market Watch – Greek euro exit would be ‘Lehman Brothers squared’: economist quoting Barry Eichengreen, speaking at the American Economic Association conference, who described a Greek exit from the Euro:-

In the short run, it would be Lehman Brothers squared.

Writing at the end of last month the Economist – The euro’s next crisis described the expectation of a Syriza win in the forthcoming elections:-

In its policies Syriza represents, at best, uncertainty and contradiction and at worst reckless populism. On the one hand Mr Tsipras has recanted from his one-time hostility to Greece’s euro membership and toned down his more extravagant promises. Yet, on the other, he still thinks he can tear up the conditions imposed by Greece’s creditors in exchange for two successive bail-outs. His reasoning is partly that the economy is at last recovering and Greece is now running a primary budget surplus (ie, before interest payments); and partly that the rest of the euro zone will simply give in as they have before. On both counts he is being reckless.

In theory a growing economy and a primary surplus may help a country repudiate its debts because it is no longer dependent on capital inflows.

The complexity of the political situation in Greece is such that the outcome of the election, scheduled for 25^th January, will, almost certainly, be a coalition. Syriza might form an alliance with the ultra-right wing Golden Dawn who have polled an average of 6.49% in the last 20 opinion polls, who are also anti-Austerity, but they would be uncomfortable bedfellows in most other respects. Another option might be the Communist Party of Greece who have polled 5.8% during the same period. I believe the more important development for the financial markets during the last week has been the change of tone in Germany.

The European bond markets have taken heed, marking down Greek bonds whilst other peripheral countries have seen record low 10 year yields. 10 year Bunds have also marched inexorably upwards. European stock markets, by contrast, have been somewhat rattled by the Euro Break-up spectre’s return to the feast. It may be argued that they are also reacting to concerns about collapsing oil prices, the geo-political stand-off with Russia, the continued slow-down in China and other emerging markets and general expectations of lower global growth. In the last few sessions many stock markets have rallied strongly, mainly on hopes of aggressive ECB intervention.

Unlike the Economist, who are concerned about EZ contagion, Brookings – A Greek Crisis but not a Euro Crisis – sees a Euro break-up as a low probability:-

A couple of years ago the prospect of a Syriza-led government caused serious tremors in European markets because of the fear that an extremely bad outcome in Greece was possible, such as its exit from the Euro system, and that this would create contagion effects in Portugal and other weaker nations. Fortunately, Europe is in a much better situation now to withstand problems in Greece and to avoid serious ramifications for other struggling member states. The worst of the crisis is over in the weak nations and the system as a whole is better geared to support those countries if another wave of market fears arise.

It is quite unlikely that Greece will end up falling out of the Euro system and no other outcome would have much of a contagion effect within Europe. Even if Greece did exit the Euro, there is now a strong possibility that the damage could be confined largely to Greece, since no other nation now appears likely to exit, even in a crisis.

Neither Syriza nor the Greek public (according to every poll) wants to pull out of the Euro system and they have massive economic incentives to avoid such an outcome, since the transition would almost certainly plunge Greece back into severe recession, if not outright depression. So, a withdrawal would have to be the result of a series of major miscalculations by Syriza and its European partners. This is not out of the question, but the probability is very low, since there would be multiple decision points at which the two sides could walk back from an impending exit.

I think The Guardian – Angela Merkel issues New Year’s warning over rightwing Pegida group – provides an insight into the subtle change in Germany’s stance:-

German chancellor Angela Merkel in a New Year’s address deplored the rise of a rightwing populist movement, saying its leaders have “prejudice, coldness, even hatred in their hearts”.

In her strongest comments yet on the so-called Patriotic Europeans Against the Islamisation of the West (Pegida), she spoke of demonstrators shouting “we are the people”, co-opting a slogan from the rallies that led up to the fall of the Berlin Wall 25 years ago.

“But what they really mean is: you are not one of us, because of your skin colour or your religion,” Merkel said, according to a pre-released copy of a televised speech she was to due to deliver to the nation on Wednesday evening.

“So I say to all those who go to such demonstrations: do not follow those who have called the rallies. Because all too often they have prejudice, coldness, even hatred in their hearts.”

Concern about domestic politics in Germany and rising support for the ultra right-wing Pegida party makes the prospect of allowing Greece to leave the Euro look like the lesser of two evils. Yet a Greek exit and default on its Euro denominated obligations would destabilise the European banking system leading to a spate of deleveraging across the continent. In order to avert this outcome, German law makers have already begun to soften their “hard-line” approach, extending the olive branch of a potential renegotiation of the terms and maturity of outstanding Greek debt with whoever wins the forthcoming election. I envisage a combination of debt forgiveness, maturity extension and restructuring of interest payments – perish the thought that there be a sovereign default.

Carry Concern

Last month the BIS – Financial stability risks: old and new caused alarm when it estimated non-domestic US$ denominated debt of non-banks to be in the region of $9trln:-

Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.

Within the EZ the quest for yield has been no less rabid, added to which, risk models assume zero currency risk for EZ financial institutions that hold obligations issued in Euro’s. The preferred trade for many European banks has been to purchase their domestic sovereign bonds because of the low capital requirements under Basel II. Allowing banks to borrow short and lend long has been tacit government policy for alleviating bank balance sheet shortfalls, globally, in every crisis since the great moderation, if not before. The recent rise in Greek bond yields is therefore a concern.

An additional concern is that the Greek government bond yield curve has inverted dramatically in the past month. The three year yields have risen most precipitously. This is a problem for banks which borrowed in the medium maturity range in order to lend longer. Fortunately most banks borrow at very much shorter maturity, nonetheless the curve inversion represents a red flag : –

Date	3yr	10yr	Yield curve
14-Oct	4.31	7.05	2.74
29-Dec	10.14	8.48	-1.66
06-Jan	13.81	9.7	-4.11

Source: Investing.com

Over the same period Portuguese government bonds have, so far, experienced little contagion:-

Date	3yr	10yr	Yield curve
14-Oct	1.03	2.56	1.53
29-Dec	1.06	2.75	1.69
06-Jan	0.92	2.56	1.64

Source: Investing.com

EZ Contagion

Greece received Euro 245bln in bail-outs from the Troika; if they should default, the remaining EZ 17 governments will have to pick up the cost. Here is the breakdown of state guarantees under the European Financial Stability Facility:-

Country	Guarantee Commitments Eur Mlns	Percentage
Austria	21,639.19	2.78%
Belgium	27,031.99	3.47%
Cyprus	1,525.68	0.20%
Estonia	1,994.86	0.26%
Finland	13,974.03	1.79%
France	158,487.53	20.32%
Germany	211,045.90	27.06%
Greece	21,897.74	2.81%
Ireland	12,378.15	1.59%
Italy	139,267.81	17.86%
Luxembourg	1,946.94	0.25%
Malta	704.33	0.09%
Netherlands	44,446.32	5.70%
Portugal	19,507.26	2.50%
Slovakia	7,727.57	0.99%
Slovenia	3,664.30	0.47%
Spain	92,543.56	11.87%
EZ 17	779,783.14	100%

Assuming the worst case scenario of a complete default – which seems unlikely even given the par less state of Greek finances – this would put Italy on the hook for Eur 43bln, Spain for Eur 28.5bln, Portugal for Eur 6bln and Ireland for Eur 3.8bln.

The major European Financial Institutions may have learned their lesson, about over-investing in the highest yielding sovereign bonds, during the 2010/2011 crisis – according to an FT interview with JP Morgan Cazenove, exposure is “limited” – but domestic Greek banks are exposed. The interconnectedness of European bank exposures are still difficult to gauge due to the lack of a full “Banking Union”. Added to which, where will these cash-strapped governments find the money needed to meet this magnitude of shortfall?

The ECBs response

Source: Bloomberg

In an interview with Handelsblatt last week, ECB president Mario Draghi reiterated the bank’s commitment to expand their balance sheet from Eur2 trln to Eur3 trln if conditions require it. Given that Eurostat published a flash estimate of Euro area inflation for December this week at -0.2% vs +0.3% in November, I expect the ECB to find conditions requiring a balance sheet expansion sooner rather than later. Reuters – ECB considering three approaches to QE – quotes the Dutch newspaper Het Financieele Dagbad expecting one of three actions:-

…one option officials are considering is to pump liquidity into the financial system by having the ECB itself buy government bonds in a quantity proportionate to the given member state’s shareholding in the central bank.

A second option is for the ECB to buy only triple-A rated government bonds, driving their yields down to zero or into negative territory. The hope is that this would push investors into buying riskier sovereign and corporate debt.

The third option is similar to the first, but national central banks would do the buying, meaning that the risk would “in principle” remain with the country in question, the paper said.

The issue of “monetary financing” – forbidden under Article 123 of the Lisbon Treaty – has still to be resolved, so Outright Monetary Transactions (OMT) in respect of EZ government bonds are still not a viable policy option. That leaves Covered bonds – a market of Eur 2.6trln of which only around Eur 600bln are eligible for the ECB to purchase – and Asset Backed Securities (ABS) with around Eur 400bln of eligible securities. These markets are simply not sufficiently liquid for the ECB to expand its balance sheet by Eur 1trln. In 2009 they managed to purchase Eur 60bln of Covered bonds but only succeeded in purchasing Eur 16.9bln of the second tranche – the bank had committed to purchase up to Eur 40bln.

Since its inception in July 2009 the ECB have purchased just shy of Eur 108bln of Covered bonds and ABS: –

Security	Primary	Secondary	Total Eur Mlns	Inception Date
ABS	N/A	N/A	1,744	21/11/2014
Covered Bonds 1	N/A	N/A	28,817	02/07/2009	*
Covered Bonds 2	6015	10375	16,390	03/11/2011
Covered Bonds 3	5245	24387	29,632	20/10/2014
		Total	76,583
* Original purchase Eur 60bln

Source: ECB

These amounts are a drop in the ocean. If the ECB is not permitted to purchase government bonds what other options does it have? I believe the alternative is to follow the lead set by the Bank of Japan (BoJ) in purchasing corporate bonds and common stocks. To date the BoJ has only indulged in relatively minor “qualitative” easing; the ECB has an opportunity to by-pass the fragmented European banking system and provide finance and permanent capital directly to the European corporate sector.

Over the past year German stocks has been relatively stable whilst Greek equities, since the end of Q2, have declined. Assuming Greece does not vote to leave the Euro, Greek and other peripheral European stocks will benefit if the ECB should embark on its own brand of Qualitative and Quantitative Easing (QQE):-

Source: Bloomberg Note: Blue = Athens SE Composite Purple = DAX

It is important to make a caveat at this juncture. The qualitative component of the BoJ QQE programme has been derisory in comparison to their buying of JGBs; added to which, whilst the socialisation of the European corporate sector is hardly political anathema to many European politicians it is a long way from “lending at a penal rate in exchange for good collateral” – the traditional function of a central bank in times of crisis.

Conclusion and investment opportunities

European Government Bonds

Whilst the most likely political outcome is a relaxation of Article 123 of the Lisbon Treaty, allowing the ECB, or the national Central Bank’s to purchase EZ sovereign bonds, much of the favourable impact on government bond yields is already reflected in the price. 10 year JGBs – after decades of BoJ buying – yield 30bp, German Bunds – without the support of the ECB – yield 46bp. Aside from Greek bonds, peripheral members of the EZ have seen their bond yields decline over the past month. If the ECB announce OMT I believe the bond rally will be short-lived.

European Stocks

Given the high correlation between stocks markets in general and developed country stock markets in particular, it is dangerous to view Europe in isolation. The US market is struggling with a rising US$ and collapsing oil price. These factors have undermined confidence in the short-term. The US market is also looking to the Europe, since a further slowdown in Europe, combined with weakness in emerging markets act as a drag on US growth prospects. On a relative value basis European stocks are moderately expensive. The driver of performance, as it has been since 2008, will be central bank policy. A 50% increase in the size of the ECB balance sheet will be supportive for European stocks, as I have mentioned in previous posts, Ireland is my preferred investment, with a bias towards the real-estate sector.

The Euro

Whilst the EUR/USD rate continues to decline the Nominal Effective Exchange Rate as calculated by the ECB, currently at 98, is around the middle of its range (81 – 114) since the inception of the currency and still some way above the recent lows seen in July 2012 when it reached 94. The October 2000 low of 81 is far away.

If a currency war is about to break-out between the major trading nations, the Euro doesn’t look like the principal culprit. I expect the Euro to continue to decline, except, perhaps against the JPY. Against the GBP a short EUR exposure will be less volatile but it will exhibit a more political dimension since the UK is a natural safe haven when an EZ crisis is brewing.