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 Greek exit 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. Today we have seen those moves begin to abruptly unwind, 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 this outcome. But the consequence of a ’Yes’ vote is far from clear-cut. A Greek government would be committed to accepting and implementing a programme to which they object. Some have suggested that the governing political party - SYRIZA - would call an immediate election rather than implement the programme, but it is far from clear that this would occur.
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 it is generally the most liquid corner of financial markets.
In fixed income, we have maintained a cautious stance on peripheral bonds through Q2, feeling that the risk of contagion is under-priced. In a disorderly exit scenario, we feel that Italian spreads should trade wider than 200bps versus German Bunds as a greater risk premium is required. Over the medium-term however, peripheral bonds should remain supported by, above all, ECB support, preventing a return to spread levels reached in 2012.
Similarly in equities we are underweight in Southern Europe and we remain cautious given the ongoing uncertainty.
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, at times appreciating on bad news. Consequently we have moved to a more neutral exposure until a clearer path is apparent.
We began to build positive positions in European equities and high yield bonds in asset allocation portfolios from the end of last year on the expectation that weaker oil, a weaker currency, more constructive private lending data, incipient quantitative easing and cheap stock and bond prices made for a positive market outlook. As stock cheapness dissipated and energy markets rebounded into April, we reduced portfolio holdings. Through a combination of macroeconomic and bottom-up analysis, we are forecasting a strong earnings outlook for European companies. But we are far from alone in this view, and the valuation picture for 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.
