Market analylsis by Edmond de Rothschild

In spite of uncertainties in Greece, there are no dead ends for markets

The deteriorating situation in Greece since a referendum was suddenly announced has aggravated equity and bond market volatility.
Without a last minute agreement, Greece will almost certainly be unable to meet upcoming debt repayments but the risk of Greek exposure for other European players will be limited given the massive European bank exit from the country in recent years and the country’s small economic influence. Losses will be essentially concentrated in Europe’s public sectors, adding a little more to government debt burden in the eurozone but not jeopardising the area’s economic viability. In other words, from a purely financial angle, Greece’s failure to repay debt will not push Euroland into crisis.
The main question is whether the Greeks want to stay in the eurozone and the answer will come after next Sunday’s referendum. There is, of course, always a chance of a last minute agreement before the referendum takes place but if it does go ahead:

• A ‘yes’ vote would quickly allow everyone to move on from this tumultuous phase. In all likelihood, the government would resign, new elections would take place and a new administration would take over. Naturally, this would take time so the country would be unable to meet its short term payment deadlines but we have no doubt that European governments are politically determined to find a solution that would help Greece weather this fragile period.
• A ‘no’ vote would open up a wide range of possibilities and would probably mean Greece leaving the eurozone. If that were to happen, the ECB would almost certainly intervene massively on bond markets to avoid any contagion. But there is also a strong possibility that the Eurogroup could announce major progress in the form of Eurobills or Eurobonds, a vigorous political gesture to counter such a sweeping political shock.
• In this way, the traumatic end to the euro’s non-reversibility would be offset by reinforced eurozone integration, only accelerating a transition that had already been mapped out by Europe’s top political leaders.

OUR CONVICTIONS:In light of this, we have chosen to stick with our investment policy even if the Greek crisis might still trigger a number of surprises and create more volatility. We have, however, taken some tactical precautions.

ON EQUITY MARKETS:
We remain overweight equities (mainly in euroland and in Japan) because the recovery that started at the beginning of 2015 is now gaining strength. There are now encouraging signals in Italy, for long the zone’s weakest link, and the US recovery has returned to growth after the dip at the beginning of the year; this will bolster estimates which see Europe growing at a rate of 1.5% in 2015. Such a pace will help European margins recover and thus ensure satisfactory earnings growth. We are also convinced that M&A deals in the eurozone, which have fallen behind due to the economic crisis and the freeze in bank lending, will rapidly make up the ground lost. The recovery in bank lending capacity is a very encouraging sign. Lastly, we are maintaining our overweight in Japan due to (i) ongoing structural reforms, especially those designed to reform company board administration to boost ROE, (ii) signs the economic recovery is underway, (iii) moves by the country’s leading pension funds to invest more in equities and (iv) the market’s relative appeal compared to others. In a situation where the recovery in the developed zone just needs to strengthen, investors should continue to focus on equities; bond yields are generally low and likely to become more unstable.

ON BOND MARKETS:
However, volatility from the tricky situation in Greece is probably not over. This is why we have increased US dollar exposure in our portfolios: the greenback could perform well if the eurozone crisis worsens and the ECB multiplies interventions. At the same time, and even with a happy end to the Greek issue, investors will rapidly refocus on monetary tightening in the US, a bullish point for the dollar. We have also tactically upgraded our rating on eurozone bonds, focusing on core countries to protect our portfolios in the event of a flight to quality and massive liquidity injections from the ECB.

Benjamin Melman – Head of Asset Allocation and Sovereign Debt – Edmond de Rothschild Asset Management (France)