Greece, Europe and the equity market
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.