Greece, Europe and the eq­uity mar­ket

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Mar­cuard’s Drago­nomics

Af­ter days of in­tense Greek psy­chodrama, with Fran­cois Hol­lande play­ing the good cop and An­gela Merkel the bad, Europe has once again served up a com­pro­mise. The deal reached on Mon­day im­poses on Greece an




GaveKal even tougher plan than the one re­jected by its peo­ple ten days ago. No doubt each of us will have a dif­fer­ent take on what the agree­ment will mean for the fu­ture of Europe—and of Greece. How­ever, surely ev­ery­one will agree with the late Chi­nese premier Zhou En­lai, who, when sup­pos­edly asked for his as­sess­ment of the French Revo­lu­tion, re­sponded that “it is too soon to tell”.

Nev­er­the­less, from an eq­uity mar­ket per­spec­tive the news is clearly pos­i­tive, as the risk of Grexit has now con­sid­er­ably di­min­ished. As­sum­ing that over the next few days Greece be­gins to de­liver on its prom­ises, in­vestors will quickly re­fo­cus on the out­look for cor­po­rate prof­its—where hap­pily there is a great deal less un­cer­tainty.

Even though the term “Grexit” has now ap­peared in the of­fi­cial lan­guage of Euro­pean Union pol­i­cy­mak­ers for the first time, the events of re­cent days have once again demon­strated that fears of the in­cal­cu­la­ble con­se­quences should the eu­ro­zone break up re­main strong enough to keep Europe on the “mud­dling through” path. The fact that a sub­stan­tial ma­jor­ity of Greeks are still in favour of keep­ing the euro, even af­ter five long years of eco­nomic hard­ship, is also telling. How much longer this con­sen­sus will last is un­known, but for now it re­mains solid.

Can Greek con­fi­dence re­cover af­ter suf­fer­ing so much po­lit­i­cal, fi­nan­cial and macroe­co­nomic dam­age? We will know soon enough whether Prime Min­is­ter Alexis Tsipras can rally enough sup­port from op­po­si­tion To Po­tami, Pa­sok and New Democ­racy mem­bers of par­lia­ment to off­set de­fec­tions from the hard left of his own Syriza party and its right wing In­de­pen­dent Greeks coali­tion part­ners. If he can, suc­cess­fully trans­form­ing him­self into a “Mit­teran­dreou” or a “Ren­z­i­man­lis”, the tax and pen­sion re­forms that the EU is de­mand­ing will be ap­proved this week, as will a sec­ond round of con­di­tions next week. Af­ter that, it will be up to Europe’s in­sti­tu­tions, in­clud­ing the Euro­pean Cen­tral Bank, to be­gin chan­nelling money to the Greek gov­ern­ment and the Greek fi­nan­cial sys­tem. If these early tests go smoothly, the plan forged over the week­end in Brus­sels will have a rea­son­able chance of work­ing.

That’s partly be­cause Greece’s eco­nomic sit­u­a­tion has changed over the last few years. The long pe­riod of ag­o­nis­ing fis­cal aus­ter­ity, which saw the Greek bud­get deficit re­duced from 15% of gross do­mes­tic prod­uct in 2009 to just 3.5% in 2014, is largely over. Had Greece not elected Tsipras six months ago, it would now be en­joy­ing a grad­ual eco­nomic re­cov­ery, a small pri­mary fis­cal sur­plus, de­clin­ing bond yields and even ac­cess to bond mar­ket re­fi­nanc­ing. If a new po­lit­i­cal ma­jor­ity in Greece can re­store a min­i­mum level of con­fi­dence, an early re­turn to a mod­er­ate pri­mary bud­get sur­plus does not look im­pos­si­ble. More­over, thanks to gen­er­ous terms from its cred­i­tors, Greece is pay­ing an ef­fec­tive in­ter­est rate of only 2.3%. As a re­sult, a nom­i­nal GDP growth rate any faster than 2.3% would be enough to be­gin to shrink the size of Greece’s debt rel­a­tive to GDP.

The start­ing point of Greece’s third bailout is there­fore very dif­fer­ent from those of 2010 and 2012, both for Greece and for the eu­ro­zone, whose econ­omy is now re­cov­er­ing, sup­ported by an ag­gres­sively ex­pan­sion­ary ECB.

Although cer­tainly tough, the deal clinched on Mon­day in Brus­sels does not con­demn Greece to eter­nal aus­ter­ity and end­less de­fla­tion. The key ques­tion now is whether, once it has demon­strated suf­fi­cient good faith, Greece will be al­lowed to fol­low much of the rest of the eu­ro­zone down the path to­wards Thatcherite Key­ne­sian­ism. Un­der this model—now adopted, al­beit re­luc­tantly, even by France and Italy—the pain of nec­es­sary sup­ply side re­forms is al­le­vi­ated by more mod­er­ate tra­jec­to­ries for deficit re­duc­tion and strong sup­port from the ECB. Whether this is a po­lit­i­cally re­al­is­tic goal for Athens is an open ques­tion. Nev­er­the­less, Greece’s eco­nomic prospects un­der the cur­rent deal are very dif­fer­ent than they were in 2010 or 2012, when the name of the game was all about mas­sive fis­cal con­sol­i­da­tion.

Af­ter weeks of suc­ces­sive po­lit­i­cal Uturns, in­vestors re­main hes­i­tant to con­clude that the Greek cri­sis is over. As a re­sult, eq­uity mar­kets have not yet ral­lied as much as they might have done. Sure, eu­ro­zone stock in­dexes have re­couped half the losses they sus­tained dur­ing the April-June pe­riod. But in the con­text of a broad­en­ing and strength­en­ing cycli­cal re­cov­ery in the eu­ro­zone, the elim­i­na­tion of Grexit risk has the po­ten­tial to drive fur­ther gains.

We be­lieve the sec­ond quar­ter earn­ings sea­son, which will start at the end of the month, should help sig­nif­i­cantly. The lagged ef­fect of the euro’s de­pre­ci­a­tion and, cru­cially, the fact that eco­nomic growth in the eu­ro­zone is now slightly above trend— prob­a­bly some­where close to 2%—should pro­duce pos­i­tive sur­prises for cor­po­rate prof­its.

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