July 2015 – A Denouement for Greece?
Once again, the Eurozone is in the crosshairs of financial markets. Taking a step back, it is peculiar that a country whose GDP is less than that of Dallas, Texas, with a population less than Istanbul should hold markets captive. Still, Greece’s technical default on a $1.7 billion payment to the IMF is another reminder of the still large imbalances that exist in Europe’s single monetary union and the structural issues that are likely to remain regardless of whether Greece remains a member state.
That being said, our core views remain intact: principally that equity markets have not yet made their highs for the year; that the U.S. dollar will continue to appreciate on a trade-weighted basis; that Japanese equity markets will outperform their developed market peers; and that high yield credit will deliver mid-single digit returns in the face of rate normalization in the U.S.
These views are supported by our belief that the Greek situation will remain relatively contained without the spill-over that was witnessed in the summer of 2012 when spreads on peripheral debt rose to 605bp for Spain (currently 149bp) and 1336bp for Portugal (currently 220bp). The differences between then and now are material, namely as a result of the continent’s stronger banking sector. According to the Bank for International Settlements, as of year-end 2014, total foreign claims of the European banking sector against Greece were $33 billion compared to its peak of $300 billion in 2010. In addition, the four systemically important Greek banks have more than 90% of the market share, meaning that European banks are fairly insulated from the arrears which are likely to pile up. What’s more, public institutions including the European Financial Stability Facility (EFSF) and IMF, as opposed to the private sector, now hold the majority of Greek debt.
The European Central Bank (ECB) is also better equipped to prevent financial market contagion. First, it is already in the midst of a 60 billion euro per month asset purchase program—better known as quantitative easing—which it could tilt towards the purchases of more peripheral debt if spreads blew out. In a more adverse scenario, the ECB could also rely on the still untapped Outright Monetary Transactions (OMT) which were announced at the height of the eurozone crisis in 2012 and allow the ECB to purchase sovereign debt. In June 2015, the EU Court of Justice ruled that this program did not exceed the powers of the ECB in relation to monetary policy, meaning that in an extreme scenario, extreme measures are at the disposal of the ECB.
Despite a more robust backdrop, we are prepared for heightened volatility and equity market weakness as investor sentiment is subject to the most recent headline or rumour out of Brussels or Athens. It is also important to acknowledge the difficulty in predicting political outcomes in Greece, especially at they relate to the durability of the Syriza government should Greek citizens support the series of reforms contained in the July 5 referendum. A “no” vote will surely increase economic instability and make it more difficult for the IMF and Europe to provide additional support to Athens as it will be seen as a vote against EU membership.
Still, we believe it is important not to lose sight of the underlying economic fundamentals in Europe which have improved over the last three months. This partially accounts for the rapid move higher in 10-year German bund yields which are pricing in a better growth outlook and rose from a low of 0.049% to around 0.760% at the time of writing. In June, eurozone PMI numbers also showed broad based improvements while credit growth continues to expand. We expect this will translate into higher earnings for European corporates which are already estimated to grow more than 10% compared to last year. The tailwind associated with a lower euro, which we expect will revisit its lows seen earlier this year will also propel earnings. European indices continue to trade at more attractive valuations than their U.S. counterparts and are in a less mature part of the earnings cycle, further strengthening our conviction on a relative basis.
Moving away from Europe, it is important to consider the second-level impacts that the Greek situation could have on other markets. While the decision of the Federal Reserve on whether to begin hiking rates is not likely to be driven by Greek events, a rapid appreciation of the U.S. Dollar amid a flight to safety would effectively tighten monetary conditions in the U.S. and could lead the Fed to reassess its timing. This is not our base case and we continue to bias our outlook on the timing of hikes, like the Fed, on incoming data.
The most recent data from the U.S., including retail sales and housing starts, is pointing to a stronger second quarter and is strengthening the case for hiking rates in September. Still, the market is evenly split between then and a December hike. This decision will largely depend on the U.S. consumer, which accounts for around 60% of U.S. GDP and who is slowly starting to spend some of the savings accrued from lower energy prices. Regardless of when the Fed hikes, we continue to believe the path and destination of rate increases (the so-called dot plot) is of greater importance.
Interest rates in the U.S. are likely to drift higher as the economy strengthens, though we expect to see a flattening of the yield curve as short-end rates adjust to rate hikes more than the longer end. The steepening in the yield curve this year has led to an underperformance in investment grade (IG) credit which has a higher duration than its high yield (HY) counterpart. For the year, the BoAML IG Index is down 0.4% while the HY Index has returned 2.30%. We think IG credit should strengthen in the coming months as spreads absorb the move higher in Treasury yields though we still expect the high yield asset class to outperform year-end.
As for U.S. equities, we continue to prefer a market weight position given loftier valuations and the combination of record corporate profit margins and near-full employment, which could induce some cost-push pressures on profits. That being said, we do not believe the highs in U.S. equities have been seen yet. The market should continue to be supported by strong M&A activity, which is up 60% for the first half of 2015 and the low hurdle for second quarter earnings.
Japan continues to be the best performing equity market, despite undergoing its first monthly losses for the year. We continue to maintain an overweight position in Japan, hedged against the yen, given still attractive valuations, steady monetary policy support and reforms aimed to unlock shareholder value.
In China, the Shanghai Composite has fallen close to 20% from its highs of the year, amid the highest volatility since 2008. Still, the market is up 108% over the last year. The H-shares market has emerged less scathed, down around 9% from its high, but up only 13% over the last year. We continue to prefer the H-shares market given its discount to the A-shares market. The push and pull between monetary expansion from the People’s Bank of China and regulations seeking to reduce margin financing for equity purchases are likely to increase volatility in the near-term.
This summer is shaping up to be a critical point for a number of market developments. Markets will continue to pivot off of the politics in Greece, incoming macro data from the U.S., and ability of monetary policy in China to sustain the country’s equity market rally and improve earnings. All of this is set against a backdrop of divergent monetary policies, heightened currency volatility and loftier valuations on financial assets which has incentived greater risk-taking among market participants. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. Notwithstanding the challenges associated with divergent central bank behavior, we believe that opportunities also exist. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.