3rd Quarter 2015

"Brinkmanship is the practice of pushing dangerous events to the brink of disaster in order to achieve the most advantageous outcome”, and it certainly would appear an art that Greek Prime Minister Alexis Tsipras has mastered in is negotiations with Greece’s Troika creditors of the European Commission (EC), International Monetary Fund (IMF) and European Central Bank (ECB).

Last Quarter Review

US equity markets largely went sideways during the second quarter, while bond markets fell markedly with the yield on the benchmark US 10 Year Treasury rising from 1.87% at the start of April to 2.49% at end June. The US Dollar, which had been in a relatively strong bull market since this time last year, fell approximately 2.5% against a basket of other currencies during the second quarter.

In the UK, markets were buoyed by the surprise (the polls had suggested a hung parliament) outright election victory for the Conservative party. Commentators suggested this was on the back of their sound management of the UK economy, which revised figures released on the last day of June showed had grown 0.4% during the 1st quarter of 2015 and not 0.3% as previously advised. Towards the end of the quarter however, both the UK and European equity and bond markets encountered severe headwinds in respect of the ongoing Greece Euro crisis.

Key Economic & Market Data 1st Quarter GDP 12 month GDP Base Interest Rate at End June 2015 Equity Index Returns - Last Quarter Equity Index Returns - Last 12 Months Sovereign Bond Index Returns - Last 12 Months
% % % % % %
USA -0.20 2.90 0.25 -0.23 +5.25 +2.81
UK 0.40 2.90 0.50 -3.70 -3.31 +8.94
EuroZone 0.40 1.00 0.05 -7.40 +6.07 +4.01
China 1.30 7.00 4.85 +10.42 +106.59 N/A
Japan 1.00 -0.90 0.00 +5.42 +33.46 +2.02
Germany 0.30 1.10 0.05 -8.53 +11.31 +4.33
NB. GDP Data shown is to the 31st March 2015; Interest Rate, Equity & Bond Index Data is to the 30th June 2015; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices courtesy of Bloomberg

Current Considerations

The Greek Euro tragedy took a new turn on the 5th July, when the electorate of the nation where democracy supposedly commenced in the 5th century, backed its government led by Alexis Tsipras by voting No in the referendum on whether to accept the Troika’s offer of increased credit in return for greater austerity. The number of people voting No was a resounding 62% and markets across the world fell sharply on the implications of the result, namely the increasingly real likelihood of Greece leaving the Euro.

It feels like the saga has been going on for ever, and many market commentators had grown weary of the whole affair long before the latest talks had begun in earnest on the 22nd June, to try and avert Greece defaulting on its scheduled repayment of €1.5 billion to the IMF, which it duly failed to meet on the 30th June. To outside observers, while Greece leaving the euro (or “Grexit” as it has been coined by the media), and walking away from debts of €317 billion or 180% of GDP may initially look attractive, the gains would in all likelihood be far outweighed by the severe economic turmoil and social and political upheaval that would follow.

However The Economist newspaper recently cautioned that averting Grexit at any cost is not a viable proposition as it explained, “Most Greeks want to stay in the euro. But their politicians still look to Berlin for salvation, rather than reform at home. Greece must understand that, if this does not change, the creditors will lose patience. Avoiding divorce would be better for everyone. But this marriage is not worth saving at any price.”

There can be no denying that membership of the euro transformed the Greek economy in 2002, as previously Greece was an European backwater, where cash in the form of the drachma currency ruled. To a large extent the Greeks still only trust cash which is why more than €30 billion was withdrawn from cash points in the weekend preceding the crisis talks. Entry to the European Union in 1981 finally brought a degree of calm to a Greek nation which had endured worrisome instability since the Nazi occupation during World War II, which included a civil war, a military junta, a tussle between Communists and anti-communists and in the 1980’s, an inflation rate over 20 percent. So sure were Greeks of the permanence of the euro that when they minted their own 1 euro coin, they paid homage to a 5th century drachma, among the world’s oldest currencies.

Greece whose economy represents just 1.8% of the Euro area naturally wants to have its cake and eat it by staying in the euro, but without restructuring or being forced to repay its debt. Alexis Tsipras is probably a lot cleverer than many give him credit for, and probably believes he can push his luck a lot further knowing that the ECB is in a tight corner with its credibility and reputation as lender of last resort at stake, as events are closely watched by the other debt deficit euro members, Spain, Portugal and Italy.

Meanwhile Richard C. Koo, Chief Economist of Nomura Research in his book “The Escape from Balance Sheet Recession and the QE Trap” suggests that it was the revelation of Greece’s profligacy that caused the euro crisis to initially erupt. Richard thinks two events were key to the way Europe responded to the 2008 crisis, and claims, “the Maastricht Treaty that underlies the euro is a defective document that makes no allowance for countries in balance sheet recessions.

“Second, the plurality of government bond markets within the same currency zone means that the self corrective mechanism for balance sheet recessions functions poorly, if at all in the Eurozone”. Richard believes the revelation in 2009 that Greece had been hiding the extent of its fiscal deficits had unintended consequences for countries such as Portugal, Italy, Spain, and Ireland, whose situation was different and where huge pools of un-borrowed private savings became the norm, as businesses and households moved collectively to repair their balance sheets, which should have resulted in their governments taking up the slack and increasing their fiscal deficits instead of cutting them as they were encouraged to do.

This Richard suggests resulted in these countries being unfairly labelled as part of the “PIIGS” problem by market commentators. Richard explains that investors have been able to exploit the flaws in the euro zone structure, which in turn has helped exacerbate the crisis as, “institutional investors who think their own governments’ fiscal deficits are too large can buy bonds issued by other, less fiscally challenged Eurozone governments without taking on any currency risk, because all government bonds in the Eurozone are denominated in the same currency and there are 17 markets to choose from.”

Perhaps unsurprisingly, Richard is highly critical of orthodox economists and pundits whom don’t appear to understand balance sheet recessions and accordingly proffer the wrong advice, “when they assume as did their counterparts in Japan 20 years ago, that large fiscal deficits imply the nation will collapse unless the government quickly takes action to right the fiscal ship. When investors in the country hear the media talk about problems of large fiscal deficits from morning to night, they instinctively become wary of that country’s bonds and turn instead to the government bond markets of Eurozone countries with smaller fiscal deficits.”

This of course results in the yields of the government bonds of the country with a large fiscal deficit rising (while its capital value falls) and, “when that happens, the government panics because higher yields indicate that the market is shunning its bonds, which prevents it from carrying out the fiscal stimulus that is essential during a balance sheet recession. Even worse, it is forced to undertake deficit-reduction efforts, the single worst thing a government can do. Conditions then deteriorate further in what becomes a vicious cycle.”

The structural reforms put forward by Richard if implemented would arguably solve these problems permanently, and include revising the Maastricht Treaty to remove the fiscal deficit cap, thereby providing much more flexibility to increase a country’s fiscal deficit during balance sheet recessions. Richard acknowledges that this change would be politically difficult and controversial as would his second solution which would complement the first, namely imposing a ban on buying other nations’ debt within the euro zone, otherwise, “even with a revised treaty and the EU’s blessing, fiscal stimulus would be impossible to administer if the un-borrowed savings of countries in balance sheet recessions fled to other Eurozone bond markets, preventing those governments from issuing debt to fund stimulus measures”.

Richard believes that had the “own country debt purchase only” rule been in place pre Lehman in 2008, the euro crisis would never have happened, and neither would the Greek tragedy since, “the Greek government would be prevented from running deficits larger than its citizens are willing to finance with their own savings. Adopting this rule would restore fiscal discipline to national governments since they could not borrow any more than their citizens are willing to lend”

Martin Wolf, Chief Economist of the Financial Times, when reviewing Richard Koo’s book back in January of this year was sympathetic to his ideas, but sceptical of the likelihood of their adoption, and said, “Neither change is likely to happen. But they are at least logical responses to the euro zone’s plight.” So sadly we are left with the ECB caught between the devil and the deep blue sea as we await the outcome of the Greek referendum on Sunday, the 5th July, with the default of the IMF’s €1.5 billion now almost certain, but more importantly if no deal between the two sides can be found before the 20th July, Greece will then default also on the repayment of a €3.5 billion bond repayment to the ECB.

So with Alexis Tsipras and his cabinet refusing (at least for now) to accept the austerity terms accompanying the Troika’s offer of a new €15.3 billion rescue package, and the ECB freezing emergency loans (€89 billion had already been made available through the Emergency Liquidity Account or ELA to counter the billions withdrawn in June) to Greek banks, Greece was forced to close its banks until after the 5th July referendum and impose capital controls. The marathon Greek Euro saga that has worried markets off and on for years looks to be entering its most dangerous phase yet, with the wrong outcome potentially having far reaching consequences for markets and investors for many more years, since actual Grexit would inevitably cause contagion fears and shift focus onto the repayment schedules of other struggling debt deficit euro members over the coming years!

Forward Outlook

While there are encouraging signs that global economic growth can continue to gain traction, with even the markets of the European Union finally showing signs of life on the back of its €47 billion a month quantitative easing (QE) package, there remain serious headwinds that can spoil the party. Of course Grexit is one very worrying problem that could destabilize markets for years to come.

Additionally the Bank for International Settlements (BIS) in its recent annual report echoed many of Richard Koo’s fears about policymakers relying too heavily on monetary policy when more fiscal stimulus is often what is required. In its first chapter titled “Is the unthinkable becoming routine”, it suggests, “Globally, interest rates have been extraordinarily low for an exceptionally long time, in nominal and inflation-adjusted terms. The economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited.”

The BIS annual report goes on to argue that the malaise it is concerned about “reflects to a considerable extent the failure to come to grips with financial booms and busts that leave deep and enduring economic scars. In the long term, this runs the risk of entrenching instability and chronic weakness. The international monetary and financial system has spread easy monetary and financial conditions in the core economies to other economies through exchange rate and capital flow pressures, furthering the build-up of financial vulnerabilities. Short-term gain risks being bought at the cost of long-term pain. Over a longer horizon, negative rates, whether in inflation-adjusted or in nominal terms, are hardly conducive to rational investment decisions and hence sustained growth. If the unprecedented journey towards lower negative nominal interest rates continues, technical, economic, legal and even political boundaries may well be tested.”

As part of the solution the BIS suggests “One essential element of this rebalancing will be to rely less on demand management policies and more on structural ones, so as to abandon the debt-fuelled growth model that has acted as a political and social substitute for productivity-enhancing reforms. The dividend from lower oil prices provides an opportunity that should not be missed. Monetary policy has been overburdened for far too long. It must be part of the answer but cannot be the whole answer.”

We shall be watching closely to see whether global central banks take heed of the BIS warnings and recommendations. Meanwhile we remain cautiously optimistic that our key preferred equity and fixed income asset classes can continue to deliver good risk adjusted returns for our investment portfolios despite increasingly volatile markets.