Whilst an exit is not a certainty at this point, the probability has significantly increased - particularly given next weekend’s critical referendum. The negative market reaction today has been modest and partially reverses the gains we saw last week. As we have said repeatedly, the consequences of a Greek default and the imposition of capital controls will have a dramatic effect on Greece but a limited economic bearing on the wider eurozone.
This is a generally accepted view, but our concern from here is the medium-term impact on the broadening economic recovery taking place in Europe right now. We will not know for some time how business confidence may be influenced by the uncertainty and fears of possible contagion to other eurozone countries, particularly the periphery.
Much will depend on unknowable Greek factors such as potential social unrest and associated media coverage, Russian involvement, the depth of the recession and so on.
It is difficult at this point to envisage European equities making much headway in this scenario. Even if we are right about the wider limited economic impact, it may take several months for the market to accept clarity around the sustainability of the eurozone recovery.
Having said that, European equity investors should remember the following crucial points. Firstly, the European Central Bank (ECB), having removed the Greek ELA (emergency liquidity assistance), has said it is scrutinising markets to ensure they are able to deal with areas of instability. The “Draghi put” is alive and kicking; the quantitative easing (QE) programme will ensure bond market contagion is very limited. The QE programme itself is, however, only in place for a certain period of time, which is why in our view the ECB and the European governments need as far as possible to resolve the Greek crisis this year.
The second point to note is that while expectations of a recovery have been factored into equity valuations to some extent, the potential for margin expansion across many European corporates remains. The current 2015 forward price-to-earnings multiple of 16x falls to 12x if we assume aggregate European margins get back to 2007 levels, which are still well below those being reported in the US.
In summary, the Greek uncertainty and possible contagion of confidence is likely to cause continued volatility and constrain the upside for European equities for a period of time. However we also believe there is reasonable downside protection given the ECB’s QE programme and current European equity market valuations.
