Grexit: Hedging the unknown
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.