We received the following question from a subscriber to The Churchouse Letter:
Great question, thanks for writing to us… and a good opportunity to look back at what we wrote in our February edition of The Churchouse Letter “A Lesson From the Mountains”.
First of all, let me repost the quote from Rudi Dornbusch that we opened that edition with:
Nowhere has this been truer than in the European sovereign bond market, which I described back then as “a gigantic accident waiting to happen”.
Take a look at the charts below. On the left, you’ll see the German 10 year bund yield movements we’ve seen in the past 2 months.
The 10 year bund fell from a price of 104 to less than 96 in just 8 weeks. That’s a huge drop for a safe haven asset like the bunds.
And on the right, you’ll get a sense of just how volatile this movement has been compared to the last decade.
Our subscribers may recall, I said the following in our February edition.
“A by-product of cheap money and central-bank policies has been low volatility.
Investors have become complacent. They’re not watching out for the next avalanche, but the fault lines and fractures are plain to see.”
I confess, I didn’t expect this quite so soon.
But going back to the original question.
A Grexit is now clearly looking more probable than before, but far from guaranteed.
Let’s face facts, Greece is on its knees. The country is broke. Since the end of 2008 its nominal GDP has collapsed by a quarter. Unemployment remains at over 25%.
Capital flight from Greek banks continues at an astronomical rate… EUR2bn this month alone. To put that in perspective, Greece needs to pay just EUR1.5bn to the IMF in less than 2 weeks to avoid default.
This will only continue… why anyone would keep their Euros in a Greek bank is beyond me.
Negotiations between Prime Minister Alexis Tsipras and his creditors are deteriorating rapidly. The tone of rhetoric coming out of the Greek parliament is now intense, with Mr. Tsipras saying yesterday that the IMF “bears criminal responsibility for the situation in the country”.
This is like a bankrupt company blaming the bank that lent it money.
As for the effect that a Grexit would have on European and U.S. stock markets? It would clearly be a negative.
I don’t think enough to trigger a major correction in the U.S., but clearly European markets will suffer.
I don’t believe for a moment that markets have priced in this risk.
While the VSTOXX* index has risen to 28 from 18 in mid April, it’s far below the levels we saw in late 2011 (46) and late 2008 (61).
*The VSTOXX is essentially the European equivalent of the VIX index in the U.S. – it’s a measure of stock market volatility implied by options pricing on the EURO STOXX 50 Index.
But more importantly, the market has absolutely no idea IF a Grexit will occur, nor what it would look like.
On top of that it is near-impossible to predict or even identify all the potential contagion effects.
The first-order consequences might readily predicted…
For example, a correction in European equity markets, a sell-off in Spanish, Portuguese and Italian government bonds. Heavy corrections in any financial assets with any kind of Greek exposure at all etc…
But trying to map out the second-order and third-order effects becomes significantly more complicated.
What about other emerging market debt? What about the high yield space? What about Asian equity markets? Other emerging markets? Would Russia step in and help Greece and further escalate regional geopolitical tensions? If so, what then?
It reminds me a little of early 1997 when I was at Morgan Stanley.
Whilst I predicted the large devaluation of the Thai Baht, the scale and violence of the subsequent contagion effect was completely unexpected.
But don’t get me wrong. I’m certainly not suggesting that a Grexit is a precursor to a crisis of Asia 1997 proportions!
I’m just highlighting that the fracture of the European single currency, if only by a nation of just 11 million people, could bring far more negative consequences that we can currently anticipate.
Some would argue that the ECB and Draghi’s bond-buying commitment would dampen any sell-off in peripheral bond yields.
Perhaps… But if you recall, the ECB commenced its bond-buying program in March of this year… and then what started in April? Two of the most volatile months in European sovereign bond markets since the 2011 crisis.
Either way, despite the increase in the probability of a Grexit, the vast majority of Greeks still want to remain in the Euro so there’s a good chance the Greek government will back down.
For the time being, we’re staying long our European equity recommendation which is up double digits.
If we see a ‘muddle through’ temporary resolution I expect it to continue tracking higher.
In the event we see an unstable Grexit then we will either look to cut the position entirely or narrow our stop-loss and minimise our downside.
We have somewhere between little and zero interest in participating in the European bond market right now!