Grexit risks extend much beyond Europe

For the last few days, Greece takes the central stage for global financial markets, almost eclipsing the latest FOMC meeting. Deadlocks in negotiations affect major markets while signs of progress trigger substantial gains

Are investors over-reacting? Probably not. We believe that Grexit risks extend much beyond Europe: systemic risks as Greek banks suffer from a material bank run while about a third of Greek loans are non-performing; geopolitical risks amid fragile equilibriums with Russia and Turkey; and of course economic risks. Many consider that a third bailout plan including Greek debt restructuring would represent a preferential treatment, unfair vis-a-vis other EMU members that went through severe austerity programs to straighten their public finances. Moreover, such a plan would only postpone the inevitable outcome. Indeed, when examining Greece fundamentals, it appears that the country should be unable to repay its debt, even halved.
Why then favor a transitory pseudo-solution? Mainly because we think that the Eurozone expansion needs time to become entrenched. At a time when global growth is still hesitating, it is critical to prevent the European recovery from faltering. Already, the implementation of ECB’s QE triggered a challenging spike in bond market volatility. And higher interest rates could compromise reflation efforts. Since mid-March, Italian, Spanish and Portuguese yields gained roughly a hundred bps, of which about 40 would be related to mounting Grexit risks. Much is at stake: a further rise in peripheral yields is to be feared, should the Monetary Union fail to demonstrate some form of debt solidarity. In turn, higher rates could revive deflationary expectations.

In this atypical backdrop we maintain a cautiously overweight stance on Eurozone equities; Yet, we keep in mind that a goldilocks scenario could unfold with first Greece and its creditors quickly signing an accord; and then over the summer, some yield compression supported by sovereign issuance seasonal patterns. Net issuance for the area is forecasted to swing from a positive forty billion in June to a negative 50 billion in July. The lesser bond market liquidity, long hidden by a plain bullish market, was revealed a month ago when growth and inflation expectations shifted. This time, it could magnify the opposite dynamics and pressure rates lower.

Jeanne Asseraf-Bitton – Head of Cross Asset Research – Lyxor