June 18, 2012
Key Points
- The June 17 Greek elections favored the pro-bailout party and allow for a likely coalition to be formed … probably the least-tumultuous outcome.
- However, kicking the can further down the road doesn't solve the eurozone's structural problems, nor does it stem contagion.
- Next on investors' radar is this week's Federal Reserve meeting, where additional easing is expected.
The Greek people went to the polls on June 17 and the party most accepting of the terms of the IMF-eurozone bailout received the largest percentage of votes. The center-right New Democracy party, led by Antonis Samaras, received nearly 30% of the vote, according to the latest tally. The left-wing Syriza party, led by Alexis Tsipras, came in second and received just more than 27% of the vote. The center-left Pasok party garnered 12% of the vote.
My report this week takes ample input from our entire research team, including Michelle Gibley, Director of International Research, and Tatjana Michel, Director of Currency Analysis.
Our bottom line is that we know no more about the future of the eurozone than anyone else. Martin Wolf of the Financial Times put it best when he wrote: "How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What's the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile."
For those expecting something dramatic over the weekend, or a major breakthrough, the reality is a bit more sobering. Although the results of the election do put off the likelihood of a Greek exit from the eurozone, the relief may only be temporary. Even though Greece has chosen engagement, we don't yet know whether Germany will blink with additional concessions. Although the election supports the polling that showed most Greeks want to remain in the eurozone, the country has fallen way behind its fiscal targets and playing catch up is a game it has proven to not play well.
Next steps
Next up will be negotiations among the parties to form a governing coalition. Currently, the Pasok party is asking for Syriza to be part of the coalition, but for now Syriza has declined. We do ultimately expect a coalition government of "mainstream" parties and also believe they'll renegotiate the terms of the bailout, but this won't happen overnight. As a reminder, the second Greek bailout in February was nearly six months in the making; however, the renegotiation could be speedier this time.
What's clear as we pore through the Greek election details is that the crisis is not just about Greece. Contagion is no longer a question, as it has already spread. The recent Spanish bank bailout may have accelerated the need for the Spanish sovereign to have a bailout of its own; the negatively reinforcing link between weak banks and weak sovereigns has not been broken; and the link to Italy has not been severed.
No elixir for stress or contagion
The muddle-through environment will likely continue, with the underlying root causes of the crisis still having not been addressed. More-lasting solutions would likely entail the establishment of banking and fiscal unions, as well as joint euro bonds, such as the European Redemption Fund. The problem is that it doesn't appear any lasting solution is a possibility any time soon.
Although stock markets rallied sharply around the globe, stress can still be clearly seen in the bond market. The chart below shows the 10-year government bond yields in Spain and Italy.
Up, Up and Away
Source: FactSet, as of June 18, 2012.
Spain, Italy … and France
There are both differences and similarities between Spain and Italy, despite their government bond yields rising nearly in tandem. Spain had a housing bubble that's presently bursting (see chart below); Italy did not. Spain's fiscal problem is a large deficit, while Italy has a small fiscal deficit but a much higher level of public debt. Italy is less dependent on foreigners to finance its debt, as Italian households have a lot of wealth on a relative basis.
Spain's Housing Bubble Still Bursting
Source: FactSet, as of March 31, 2012. Data indexed to 100.
However, the two countries are similar in that they lack meaningful economic growth prospects, have uncompetitive and inflexible labor markets, and are experiencing a slow-motion flight of deposits from banks. On the surface, Italy has stronger fundamentals than Spain and it isn't yet clear that Italy needs aid. But as always, sentiment is key—the crisis boils down to confidence. The first rule about bank runs is that you don't talk about bank runs. Open talk that Italy may need aid, by both the German and Austrian finance ministers, exacerbates the situation and is yet another confidence gaff in the crisis.
Structural changes have been resisted throughout Europe. Labor reforms are needed to allow companies to be more responsive to changes in demand by being able to fire workers without excessive costs. Attempts at labor reform in Italy have been watered down and France's new President Francois Hollande appears to be moving backward. His administration is slated to introduce legislation to increase the costs to fire workers and shift production to lower-cost locations. Plans to spark growth via infrastructure projects are only a short-term band-aid.
At this point, we're not expecting a default by Italy, and for reference, the credit default swap market is pricing in about a 40% chance that Spain will default on its debt over the next five years, with a smaller chance of a default in Italy.
Europe's credit crunch
TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union, and data for May was released last week for several of the eurozone countries. Over the past year through May, the data show a significant net deposit outflow of euro from Spain and Italy and an even more significant net inflow of euro into Germany. It highlights the imbalance in the payment system and indicates uneasiness of banks clearing with each other, and instead going through central banks.
Widening Imbalance
Source: FactSet, Institute of Empirical Economic Research - Universität Osnabrückas of May 31, 2012.
The crisis has flowed through to the real economy in Europe as well, with recessions in several countries and spreading, made all the more painful due to the contraction in lending, shown in the chart below.
Lending About to Go Negative
Source: FactSet, as of April 30, 2012.
European banks are likely to remain hobbled. A potential bank union would likely increase costs and regulations for banks, and potentially result in consolidation in the number of banks in Europe. While there will be winners and losers, the adjustment period could be difficult, as we've seen in the United States in the post-Lehman Brothers period.
Currency implications
Tatjana Michel feels the outcome of the Greek elections was positive for the euro, at least for now. As for the longer-term survival of the euro, we believe it depends on leaders' ability to come up with sustainable solutions to the crisis, including the aforementioned joint euro bonds; pan-European bank deposit insurance, similar to the FDIC in the United States; or a full banking union. But the ratification of measures like these could be bumpy and take time, as they require national referendums. Overall, given the many uncertainties, we cannot exclude the risk that Greece or even another country might have to leave the eurozone in the future.
If only Greece were to leave the eurozone down the road and the Europeans come up with more-sustainable solutions for the debt problems of the remaining countries, we believe the euro has a good chance to survive. If the eurozone members fail to deliver results that increase confidence, we believe that a significant depreciation and even a breakup of the eurozone would become more likely.
The direct effect of Greece leaving the eurozone would likely be relatively small, as it makes up only 2% of eurozone gross domestic product. The risk for the euro from contagion through the bond market and the interconnection between the European banks is much larger. A further rise in Spanish and Italian bond yields, as well as a continuation of outflows of bank deposits, could exacerbate the crisis. An eventual Greek exit would likely lead to a massive depreciation of the new Greek drachma against the euro and other currencies.
Fed action coming?
The latest action in the markets has been decidedly "risk-on," with stock markets rallying and the dollar weakening, partly in anticipation of central bank action either in the United States or globally. The outcome of this week's meeting of the Federal Open Market Committee may depend partly on what's unfolding in Europe. The possibility of action by the Fed has increased, even with the "positive" election outcome in Greece. US economic data has weakened over the past couple of months, similar to the mid-year slowdowns over the past two years.
We believe the most likely move by the Fed will be to extend Operation Twist, scheduled to expire at the end of June. This would involve the Fed continuing to roll over short-term debt into longer-dated securities—possibly with a focus on mortgage-backed securities—in the interest of pushing down longer-term mortgage rates. Kathy Jones, Schwab's head of fixed income, will be penning the report after the Fed meeting this week, so stay tuned.
The problem is that each round of easing by the Fed—rounds one and two of quantitative easing (QE1 and QE2), followed by Operation Twist, in conjunction with the European Central Bank's (ECB) Long-Term Refinancing Operations—have produced diminishing returns, as least as far as the US stock market is concerned.
Diminishing Returns From Fed Ease
Source: FactSet, Strategas Research Partners, as of June 15, 2012. Corresponding colored dots represent trough-peak price only return.
Global central bank action coming?
But it's not only the US central bank that's under scrutiny. Late last week, UK Chancellor George Osborne announced a new "funding for lending" scheme amounting to about 80 billion pounds ($125 billion). The Bank of England will provide low-rate loans to banks for several years in exchange for the banks lending money to households and businesses.
Also late last week, ECB President Mario Draghi suggested that the ECB would lower interest rates and provide more liquidity as needed, noting that inflation remains subdued. In addition, according to The New York Times, the ECB is working on some sort of "grand plan" which would include "measures to prevent bank runs and reduce what has become a vicious cycle of government debt problems turning into banking crises, as has happened in the past two years. In addition, the plan will push for countries to remove the regulations and layers of bureaucracy that inhibit competition, keep young people out of the work force or make it difficult to start a new business."
Under the plan, eurozone leaders will "seek to establish the central banks as supreme bank regulator with broad powers, in place of the relatively toothless European Banking Authority. Countries would also create a deposit insurance program to augment national programs. The goal would be to reassure ordinary depositors and prevent bank runs, in imminent danger in Spain as well as Greece." While a banking union is scheduled to be discussed at the EU Summit on June 28-29, it's a complicated process that's unlikely to be resolved in the short-term, in our opinion.
Finally, over the weekend it was reported that international bank regulators would loosen Basel capital requirements to make it easier for banks to meet liquidity targets. The variety of assets that can be included in banks' liquidity buffers will be expanded to include equities and gold.
Bottom line
We expect more volatility, exacerbated by weak trading volumes. Fewer institutions, speculators and individuals opt to trade when there's outsized political versus fundamental risk, so each trade has a magnified impact and price moves can be sharp and sudden. The dramatic spike in Italian and Spanish yields can be partly explained by this phenomenon. However, thin volumes also send a message about not being overly judgmental about the moves.
Important Disclosures
