Grexit: Hedg­ing the un­known

Financial Mirror (Cyprus) - - FRONT PAGE -

As Athens and its cred­i­tors inch painfully to­wards a deal that should see the re­lease of fresh bailout funds, the prob­a­bil­ity that Greece will be un­cer­e­mo­ni­ously ejected from the eu­ro­zone is di­min­ish­ing. Grexit has never been Gavekal’s core sce­nario, how­ever we have long held the view that while the chances of a Greek exit may have been rel­a­tively small, the dam­age it would have in­flicted on fi­nan­cial mar­kets would have been dis­pro­por­tion­ately large.

The main rea­son for this is that Grexit would com­pletely dis­credit the pledge that the euro’s adop­tion is ir­rev­o­ca­ble. The mar­ket would once again al­lot euro fi­nan­cial as­sets the in­fa­mous re­de­nom­i­na­tion risk pre­mium that the Euro­pean Cen­tral Bank has worked so hard over the last few years to stamp out. This re­de­nom­i­na­tion risk pre­mium would vary across coun­tries depend­ing on eco­nomic and po­lit­i­cal de­vel­op­ments, and its re-emer­gence would slow and prob­a­bly even re­verse the on­go­ing re­vival of cross-bor­der fi­nan­cial flows in the euro area, with neg­a­tive im­pli­ca­tions for eco­nomic growth in the re­gion.

But is the risk so clear-cut? When deal­ing with the un­known, what is im­por­tant is not one’s opin­ion about the likely con­se­quences of an event. What re­ally mat­ters is what the bulk of in­vestors and eco­nomic agents con­clude. To­day, there are at least two broad rea­sons why we might have been too pes­simistic about the con­se­quence of a Grexit.

1) Even though “Grexit” has now en­tered the vo­cab­u­lary of of­fi­cial pol­i­cy­mak­ers, fi­nan­cial mar­kets have not pan­icked. It could well be that the ma­jor­ity of in­vestors con­sider that Greece, with its Balkan-style gov­er­nance and ad­min­is­tra­tion of Marx­ists and an­ar­chists, re­ally is an aber­ra­tion that de­serves a spe­cial treat­ment. The risk that the hard left could win an ab­so­lute ma­jor­ity in the up­com­ing gen­eral elec­tions in ei­ther Por­tu­gal or Spain borders on zero. Even Por­tu­gal is now en­joy­ing a sub­stan­tial re­cov­ery in both eco­nomic growth and em­ploy­ment, and—un­like Greece—it ben­e­fits from the ECB’s mas­sive pro­gramme of quan­ti­ta­tive eas­ing (QE). As a re­sult, the gulf be­tween Greece and the sec­ond weak­est link in the eu­ro­zone is now con­sid­er­able. For ex­am­ple, in April, the un­em­ploy­ment rate in Greece stood slightly more than 12 per­cent­age points higher than in Por­tu­gal— by far the high­est spread in mod­ern history—com­pared with a spread of zero in May 2010. The ev­i­dence that Por­tu­gal is not Greece is now con­clu­sive.

2) Ex­pe­ri­ence shows how dif­fi­cult it is to pre­dict the im­pli­ca­tions con­fi­dence shock.

In early 2013, when the eu­ro­zone’s Ger­manic pay­mas­ters de­cided to bail-in the banks of Cyprus, hit­ting their de­pos­i­tors hard, many observers con­cluded that a wave of bank runs would fol­low. The gov­ern­ments of Europe’s weak­est economies did not have the means to guar­an­tee de­posits with any cred­i­bil­ity, and it would not have been sur­pris­ing if house­holds and busi­nesses in Por­tu­gal and Spain had looked at the Cypriot bail-in and con­cluded that it was safer to keep their money else­where. But the feared ex­o­dus never ma­te­ri­alised, and af­ter a few weeks of un­cer­tainty things set­tled down, leav­ing Europe’s fi­nan­cial sys­tem and econ­omy com­pletely un­af­fected. The Cypriot prece­dent demon­strates that in the ab­sence of a di­rect i mpact, the i mpli­ca­tions of neg­a­tive psy­cho­log­i­cal shocks are un­pre­dictable. Nasty domino ef­fects may or may not re­sult, and fore­cast­ing them is a highly spec­u­la­tive ex­er­cise.

It is there­fore con­ceiv­able that a Grexit— again not Gavekal’s core sce­nario—could have only mod­est and tem­po­rary neg­a­tive im­pli­ca­tions for fi­nan­cial mar­kets. Con­sid­er­ing that all other sce­nar­ios—an 11th hour deal, or a de­fault lead­ing to a change of gov­ern­ment —are all favourable for fi­nan­cial mar­kets, what should in­vestors do?




The re­cent sharp cor­rec­tion in bund prices of­fers at­trac­tive op­por­tu­ni­ties. In­vestors can hedge our rec­om­mended above-bench­mark ex­po­sure to Euro­pean eq­ui­ties against the pos­si­bil­ity of Grexit by buy­ing calls on the very liq­uid bund fu­tures mar­ket. The strat­egy should be cal­i­brated to en­sure that each -30 to -40bp de­cline in bund yields off­sets a -10% de­cline in eq­uity prices. If the 10-year bund yield re­turns from 0.80% to­day to al­most 0%, as it did in midApril, eq­uity in­vestors would be pro­tected against a -20 to -25% de­cline in eq­uity mar­kets, which on the back of a -10% de­cline since mid-April, should be ad­e­quate.

If a more pos­i­tive sce­nario than Grexit oc­curs, the down­side of a bund hedge should be mod­est as bunds, while clearly not cheap, are no longer over­bought. Non-euro based in­vestors might con­sider a sim­i­lar hedge us­ing US Trea­suries in­stead of bunds.

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