European developments - 6th January 2015. I think there are three key issues at play in Europe in 2015: weak growth, rising risks of deflation due to lower oil prices and the potential for a Greek exit from the currency union (hereafter termed Grexit): 1. Weak European growth - There is no doubt that the ECB is struggling to revive the regional economy despite negative interest rates and an impending QE program, the latter of which will do nothing to boost growth as households and businesses aren’t borrowing en masse, and banks don’t want to expand their lending books. The QE itself is predominantly a financial markets event which has been factored more into bond markets than equity markets, and which is designed to keep real interest rates low in times of low or negative inflation. 2. Deflation – Another large theme that markets will have to deal with this year is the recent sharp adjustment in oil prices, with West Texas Intermediate closing at USD50 a barrel overnight, which is a decline of -53% over the past six and a half months. The US shale revolution, Saudi Arabia’s refusal to cut production and a weak world economy have combined into the perfect storm to drive down to oil prices to levels that make some of the US shale projects unviable in the medium-term. Nevertheless, the oil price decline is likely to prompt a sizable decline in global inflation in 2015 although this effect will wash through within 12 months unless oil continues to decline over the medium term. The view has firmed recently that the Eurozones annual headline inflation for December 2014 (which is published this Wednesday) has declined into negative territory. The ECB would not be concerned about a couple of months of declining consumer prices, but would be worried it this trend was more permanent and began to impact consumer behaviour (i.e. people stopped spending now because things will be cheaper in the future) and wage rates, as this creates a more dangerous re-enforcing downward spiral as unemployment rises in line with declining spending and these feed off each other. 3. The Grexit - Recent events in Greece have probably encouraged QE opponents at the ECB to increase their resistance as much as advocates say it is now essential. Regardless, the risk of deflation would trump every other concern given the region’s extremely high debt burden. Reports over the weekend claimed that Germany was prepared to allow Greece to exit the currency union if the populist Syriza party was to win this month’s Greek parliamentary elections and renege on their debt burdens and reform program. Berlin denied these reports and insisted that it expected Greece to remain in the bloc and to meet their obligations. This election will be about a choice between anger at the current Greek government and fear about what default and exit means for living standards. Importantly, policy developments since the 2011 European debt crisis suggest that a ‘Grexit’ would now be less damaging to the rest of the Eurozone, but any exit would nonetheless be very messy and destabilising. The clear factor to consider here is what is likely to happen. Polls suggest that the Syriza party is likely to win the election (four percentage ahead in the most recent poll), but they may not win by enough to have a clear majority. Let’s assume Syriza receives majority support, they then have to decide whether to renegotiate with the Troika, or tell them they are going to default. When you think about it, if Greece were ever to default, now would be the time as its fiscal deficit is small (-3% of GDP) and the country is running a primary surplus (i.e. a surplus before interest payments, which would be zero if you default) so there would be no immediate fiscal contraction. The primary owners of Greek government bonds are the IMF, the ECB and the ESM which will have to write their Greek bonds down to zero. However, by defaulting Greece will have to leave the Euro and financial conditions would tighten as the new Drachma depreciates and interest rates rise. The corporate sector would probably see their cost of capital rise by at least the same amount as the Drachma depreciates (circa -75%), which would amplify losses in earnings and the labour market. Greek banks may need bailing out by the Greek central bank or the ECB (whose interest would still be best served by bailing out any bank within the region, despite the default) and the country would suffer a large recession and higher inflation, and the central bank would have to choose which of those problems to address with its monetary policy. My guess is be that policy advances made in recent years are not adequate to ensure a smooth ‘Grexit’, but reforms in other countries will reduce the contagion effect, but will not prevent it entirely. In short, while much hangs on the election, there is a clear risk that growing uncertainty over Greece’s future in the Eurozone will have broader market effects in 2015. The ramifications for the rest of the periphery would be crucial. Rejecting unilateral haircuts for Greece would send a strong signal to all highly indebted periphery countries, but might increase the desire of the new Greek government to leave the currency union. If the Europeans collectively want to avoid sovereign defaults, then they have to accept that interest rates need to be equivalent to nominal GDP growth, which is set to be anaemic at best. This can only be accomplished by a QE program which is so large that it drives real and nominal bond yields lower and all eyes will be on Mario Draghi in the next couple of weeks and months. Meanwhile, we have to remember that Syriza is a political party whose sole purpose is to win power. Accordingly, my base case is that they will play hard ball with the Troika and will negotiate better terms (in terms of maturity extensions and interest rate cuts on principle repayments) but will not outright default. Keep in mind this is a best case scenario, markets are likely to be volatile until this plays out and that firms with strong balance sheets and high earnings quality are likely to outperform. Regards, Matt Sherwood Head of Investment Markets Research
Posted on: Wed, 07 Jan 2015 01:55:39 +0000
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