Europe: Moving towards clarity

Greece’s political and financial roller-coaster ride over whether to accept tighter conditions for a third bailout programme of up to EUR 86 bln finally came to an end during a weekend summit that ran into the business hours of Monday, July 13, underlining how close a Grexit was.

As the ‘last chance’ deadline of July 20 approached, failure to reimburse maturing Greek bonds would have left the ECB with little choice but to stop its Emergency Liquidity Assistance (ELA) for Greek banks, triggering a collapse of the Greek economy. Against this background, a broad national unity front in the Greek parliament acknowledged economic reality and the will of the Greek people to stay in the eurozone by countering the ‘No’ vote of the July 5 referendum and accepting the tougher conditionality of the proposed ESM programme.

Delivering the first reform steps by passing the laws it was required by Greece’s creditors was a constructive first step. It permitted negotiations on the ESM programme and bridge financing to progress. The ECB facilitated the reopening of Greek banks with two EUR 0.9 bln increases in the ELA facility.

The roadmap for fast tracking delivery of a third bailout package is now being followed. But is this the end of the Greek saga? We don’t think so. First of all, the devil is in the detail. For example, the International Monetary Fund reiterated its request for more debt restructuring, and Greece has a bond due for repayment on August 20. Secondly, even after the approval of a third bailout package, political and economic instability could over the coming months still trigger a downward spiral in Greece – and result in a Grexit – although we believe this is now less likely.

Also less likely, in our view, is a scenario whereby Greece would continue to captivate financial markets as it has in recent months, because the potential channels of contagion are shrinking. There is a clear will to keep Greece in the eurozone and to support the country. But even if Greece was not to meet the new conditions or modernise its economy, there would be a ‘plan B’. The writing is on the wall, the euro summit having replaced uncertainty with some clarity. As a result, European equities bounced back, peripheral spreads narrowed substantially, and the pressure on German Bund yields was muted. The EUR is currently moving in a range of 1.08 – 1.12 against the USD.

Better visibility on Greece’s situation is also reducing the threat of risk-off market sentiment contagion being channelled more broadly across the eurozone. The real eurozone economy has barely reacted to the negative media hype around Greece – indeed, underlying growth in the eurozone has, in our view, strengthened and become less vulnerable to shocks.

Spain in particular has entered a solid growth trajectory (unemployment in Q2 fell by 1.4 percentage points to 22.4%, the lowest level since Q3 2011), and data for Italy also points towards a return to an upward trend. The eurozone composite sentiment PMI has fallen slightly so far during July, from 54.2 to 53.7 and is pointing to a pace of growth in the eurozone at the start of H2 2015 similar to that achieved in H1. Further strengthening of investment and/or fewer headwinds from global trade are needed for growth to accelerate.

The minutes from the July meeting of the Bank of England (BoE) monetary committee show that uncertainty over the eurozone led to a unanimous vote for keeping UK monetary policy unchanged. However, this masks an underlying change in the mood of BoE, due to strong fundamentals, confirmed by a reacceleration of GDP growth to 0.7% QoQ in Q2.

The BoE has started to prepare markets for a first rate hike, which we expect in Q1 2016. The timing will be more and more data dependent as stronger growth and rising wages could increase the pressure on the BoE despite the absence of inflation (0.0% YoY in June).

In any case we would expect only tightening and no action before the a gradual Fed starts pace of hiking.