How do we see the current situation in the Eurozone?
Recent political developments in the Eurozone have created severe instability and uncertainty to the extent that the risk of a break-up of the union is greater now than at any point since the onset of the crisis. The fiscal compact, which was agreed earlier this year, aimed to secure the future of the Eurozone and initially brought some stability to markets. However, it has been undermined, possibly fatally, by a growing backlash against austerity manifested in the collapse of the budget-cutting coalition government in the Netherlands; the election of socialist Francois Hollande as President of France; and the collapse of a dysfunctional Greek polity. The immediate result for equity markets will be continued volatility for the foreseeable future.
The most pressing issue now is the possibility that Greece will leave the Eurozone. Although in the run-up to new elections in June, polls indicate that a clear majority of Greeks want to stay in the Eurozone, it is not at all certain that any one party will win a majority; or if it does, that the party elected would not anyway then breach the terms of the current bailout. As a result, we think the probability of Greece leaving the Eurozone has increased to at least a 50/50 chance. The markets and the corporate sector are already preparing for this eventuality.
Germany will do everything it can to prevent it. Indeed, Germany is already showing greater willingness to compromise on the issue of growth measures for peripheral countries while Bundesbank President Jens Weidmann recently stated that Germany could tolerate higher inflation in the future. It is not hard to see why; a Greek exit could lead to complete break-up of the euro and it would require a monumental effort on the part of politicians and monetary authorities to contain the impact and prevent a systemic financial crisis and global recession.For the time being the German game-plan is to wait until the Greek electorate accepts that the economy faces long-term austerity whether it is inside or outside the Eurozone. But that may not happen, and, given Greece’s dire economic and fiscal plight and the potential ongoing huge costs of keeping it in the Eurozone, Germany might have to accept a Greek exit as the least bad outcome.
What happens if Greece leaves?
This would have two negative consequences: (i) people would no longer trust in the survival of the Eurozone and (ii) the economic benefits of the single currency would largely disappear. There’s a very real risk that this would result in a bigger Eurozone upheaval, or even a collapse, in turn leading to a global crisis. Limiting the impact would not be easy. Assuming Greece does not try to maintain its austerity programme outside the Eurozone, it would move from a managed to a disorderly default. This would likely trigger bank runs in Portugal, Ireland, Italy and Spain, and even further afield. It could also cause collapses in the prices of financial and other assets in these countries. A flight to safety, to Germany or beyond the Eurozone, could accelerate. A decisive response from the Eurozone would be required to prevent severe contagion. Germany would have to allow the ECB to become lender of last resort on an unlimited scale, replacing money taken out in bank runs. Interest rates on sovereign debt would need to be capped by external measures, such as bond support schemes, and banking systems would have to be recapitalised. Above all, the commitment to keep the rest of the Eurozone together would have to be reinforced. That would demand stronger forms of fiscal solidarity. Essentially the choice would be between a much stronger union or none at all.
For Greece, the consequences of a disorderly collapse brought about by a cessation of official external funding could be even more catastrophic. The ECB would argue that Greek banks no longer possess good collateral which would prevent it from operating as a lender of last resort.
There would be comprehensive bank runs. Athens would impose exchange controls, introduce a new currency, redenominate domestic contracts and default on external contracts denominated in euros.The result could be chaos. As Greece runs a primary budget deficit (i.e. government revenues minus expenses other than debt interest) they would be unable to pay the salaries of public officials. Looting and rioting could occur as unpaid police officers and soldiers would be unlikely to keep order. A coup or civil war would be a real possibility. The new currency would depreciate dramatically and inflation would soar. In the medium run, however, order might be restored. If a) Greece managed to bring its fiscal deficit under control, b) its exporters were able to retain access to the European Union market, and c) the tourist industry also benefited from a very weak currency, then Greece might enjoy a strong recovery at some stage.
What are the implications for European equities?
The changing political dynamics in Europe have already led to a marked divergence in the performance of core and peripheral European equity markets. This likely will continue. As the events of last year showed – when it appeared that the European banking system might collapse – the materialisation of significant tail risks cannot be totally discounted. However, central banks have shown that, if pushed, they will do whatever they can to offset such tail risks.Continued steady economic growth in the US coupled with generally attractive valuations – MSCI Europe 12-month forward PE of 10X – will, in our view, provide a natural floor to equity prices at some point. Although the risks to current consensus estimates of corporate earnings are still weighted to the downside, this is now more than adequately discounted in forward-based valuations following the substantial downgrade to earnings’ estimates in 2H11. However, the recent political developments and renewed
What are the potential positive catalysts for equity markets?
We expect solid equity fundamentals and global economic data to provide support, but equities will remain volatile until there is some resolution to the Eurozone situation. As stated above corporate earnings’ forecasts were substantially cut in 2H11, but in recent months the earnings’ revision ratio (the number of upgrades less downgrades divided by the number of estimates) has improved. If this continues it will provide a support for equity markets. From a macro viewpoint continued monetary easing will be a positive catalyst. If the US economic recovery falters then we are likely to see further policy action from the Fed as well as continued easing from China. Globally the economic data should remain robust enough to give a measure of support.
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