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Market Review & Outlook

• Risk of Greek exit (even if unintended) back to levels it was when referendum was proposed last year
• Uncertainty about elections and possibility of negotiating with the Troika could prompt a run on Greek banks; will the ECB step in?
• China data disappointing, but several considerations suggest a more measured interpretation

Market changes over the past week

Greece and the eurozone

The situation in Greece is becoming more preoccupying by the day. No party leader has been able to form a government and new elections may need to be held next month, while the rising popularity of the anti-bailout Syriza party means they would likely receive the greatest number of votes. The Syriza party leader Alexis Tsipras says the country should reject the terms of the country’s bailout, take over the banks and impose a moratorium on debt repayments. It is conceivable that pressure from the Troika and a realisation of the economic consequences for Greece of such a decision (ejection from the eurozone, hyperinflation, an even deeper recession), could lead a new government to choose less drastic actions. Polls still show that 78% of Greeks want to keep the euro. But uncertainly in the meantime may lead citizens to pre-emptively withdraw their euros from the banking system if they fear the sudden imposition of capital controls and the conversion of their euros to new drachmas at an unfavourable exchange rate. If a bank run did begin to materialise, it is impossible to know what support Greece would receive from the ECB if the government was no longer committed to the existing agreements (see chart).

Ironically, Greece is a perfect illustration of the need for a ‘growth compact’ to accompany austerity. The growth component is the part of the bailout packages which require reforms to numerous parts of the economy. For example, if the unemployed could find jobs as taxi drivers where they were excluded before, or in other restricted professions, the economy would eventually recover. Borrowing money to hire civil servants or to spend on public works (another Olympics, anyone?), will work no more in the future than it did in the past.

Greek money supply and ECB funding

click to enlarge chart

Spain

It wasn’t just Greece (and France) that has jangled investor nerves, but Spain as well as the government announced yet another attempt to address souring property loans. Until it is possible to better estimate what total losses are likely to be (which will require an honest assessment of current valuations as well as at least a levelling off of the percentage of doubtful loans), yields will stay elevated (they are currently around 6% on 10-year debt) and the equity market will suffer. Spain is particularly vulnerable because of the composition of its stock market, as the financial sector has a very high weighting. The average weighting for the sector in the MSCI ACWI was 22% in December 2007 (before the collapse of the sector globally), compared to almost double that for Spain. Since bank stocks have performed the worst in Spain since 2007, the broad market has consequently underperformed the rest of the eurozone and is likely to continue to do so.

China

To top off what was already a difficult week, most of the data out of China was disappointing, and the stock market reflected it by falling 6.2%. We believe it is important not to become too pessimistic, however. Certainly we have not seen the rebound that we were expecting. Nominal exports grew by just 4.9% compared to Bloomberg consensus estimates of 8.5%, and import growth was essentially flat when it was forecasted to rebound by 10.9%. A few considerations, though. First, both import and export prices have been falling so this depresses the nominal value of trade; in real terms both exports and imports have been growing. Second, as shown by the government’s announcement to reduce the reserve requirement ratio (RRR), there is still plenty of scope to stimulate the economy. Fortunately, inflation statistics also announced last week showed the rate of increase of both headline and ex-food prices is falling. Finally, net exports have not been an important contributor to Chinese economic growth for the last several years. For 2011, consumption accounted for 77% of the annual growth rate and capital formation 33% (net exports were -10%). That said, industrial production figures were below expectations as well, so on balance a disappointing, but not catastrophic, picture.