Greece – one month on

It is now one month since Syriza came to power in the Greek general election. Much has been said across Europe, many meetings held but little has changed.

Syriza said, both ahead of and immediately after the election, that they would immediately and unilaterally throw out the Troika (the term for the EC, ECB and IMF group that oversaw Greece’s adherence to the bailout conditions imposed) to regain sovereignty over economic policy and end austerity. They said that they would demand a haircut on the amount of debt owed and that the rest of Europe would agree to this because it was (a) fair and just and (b) Europe would be scared that Greece might pull out of the euro and set off a chain reaction amongst other members that would call into question the very existence of the single currency.

Over the last few days Syriza has backed down from all of these demands, with apparently very little gained in return. Europe has stated very clearly that any write-down in the value of the outstanding debt is unacceptable to them, and Europe has continued to demand that the same trio of institutions (though now called the institutions rather than the Troika) determine whether Greece is complying with its obligations under the original bailout agreement. Also rather than anything happening immediately as Syriza demanded further discussions will take place over the next four months and conclude just before Greece is required to repay the next tranche of its debt.

It seems difficult to argue anything but that Syriza has failed miserably to deliver what it had promised the Greek voters – and indeed the risk now is that Syriza is unable to get its own MPs to give parliamentary approval to what it has agreed with Europe – which would lead to a new crisis.

With a finance minister who was formerly a professor of game theory, everyone was interested to see the negotiating techniques that Syriza adopted. At the time, and even more so with hindsight, they do not seem to have been very smart. The first acts of Tsipras and Varoufakis (the prime minister and finance minister) seemed designed to upset and offend the Germans, which may have good for domestic politics, but not ideal for bringing on board the key decision-maker in reaching agreement with Europe. They also made significant concessions very early – within a few days of coming to power, Tsipras was saying that Greece intended to repay every euro of its debts. Syriza’s maximum leverage was always likely to be immediately after the election, when “democracy” was on their side – by allowing discussion to go on for another four months they will lose that benefit. Finally it became clear as time went on that the “disaster” scenario of Greece pulling out of the euro, was something that Germany was quite prepared to live with (indeed many Germans are actively campaigning for it) whereas Syriza did not have a mandate to allow that , given that 70% of Greeks want to remain in the euro.

By contrast, Europe, led by Germany but strongly encouraged by both other Northern countries such as Finland who share the German approach to economic discipline, and by Southern countries such as Spain and Portugal, who have been through similar austerity programmes to Greece without (much) complaint and did not see why Greece should get any special treatment, played their hand in a very robust style. Schauble, the German finance minister seemed to revel in the role of “euro-enforcer”, and has insisted on Greece backing down on almost every substantive element of their demands.

The lessons from the last month seem to be (i) when going into a negotiation you need a credible fall-back position if you can’t get what you want – Syriza rather put a gun to their own head and threatened to shoot, (ii) Syriza, by conceding externally in Europe, may well have lost credibility internally, disappointing both many of their own party members and many Greeks who voted for them and (iii) Europe does not recognise democracy as an appropriate reason to go against past agreements and the rule of law (Juncker has made this point explicitly) – it should now be abundantly clear that being a part of the euro means a substantial loss of sovereignty for a nation, especially if they have a weak financial system.

Not much has changed in the last month. Greece is still stuck with debt it will never be able to repay, the Greek government has almost no say in how its economy is to be run, and the European political class have asserted their right to ignore the results of democracy in their quest to maintain the structurally-flawed single currency. This is not a long-term equilibrium – there are more crises to come.

“Alptraum” – German for nightmare

Recent events in Europe have seen many of Germany’s worst fears come true.

  • January 22 saw the ECB finally agree to initiate a policy of Quantitative Easing despite the objections of the German members on the Council. The ECB, supposedly created in the image of the Bundesbank, is now committed to a policy of money creation whose deliberate target is to increase in the inflation rate. Both the policy and its objective are in violent opposition to all that German monetary policy has sought to achieve over the last 70 years.
  • January 25 saw the Greek election result in Syriza polling far higher and thus gaining many more seats than had been expected. Instead of choosing to go into coalition with a more moderate centre-left party, Syriza formed a coalition with the far-right Independent Greeks, with whom they disagree completely on most issues but are agreed on one key policy – the tearing-up of the bailout agreements. The Independent Greeks are strongly anti-Germany and wish to reclaim war reparations they claim Germany owes to Greece. Today Greece now has what is arguably the most anti-German and authentically communist government in the European Union. The coalition are committed to tearing up the bail-out agreements signed by previous Greek governments and are demanding that much of the debt they owe be written off. Germany was a necessary, but very reluctant, party to these agreements as they appeared to compromise the key “no bailout” clause of the Maastricht Treaty.
  • January 26 witnessed Tsipras’ – the newly sworn-in Greek prime minister – first act paying a visit to the Kesariani rifle range, the site of a memorial to 600 Greek resistance fighters who were executed in a single day in 1944 by German occupying troops. The symbolism of Greek resistance to German subjugation today through opposition to the hated bailout agreements was clear and very deliberate.
  • Following this visit, the first ambassador that he decided to meet with was the Russian ambassador, who re-affirmed Russia’s readiness to provide financial support to Greece should they require it. The EU’s policy of sanctions on Russia, of which Merkel was a key influence and driver last year, has to be extended in the summer and requires unanimity from EU members.
  • The first domestic policies that the new government intends to enact are an end to planned privatisations, a large increase in the minimum wage, the re-establishment of thousands of public sector jobs that have been cut in recent years and increases in pensions. All of these will make meeting the targets for the Greek budget deficit impossible to achieve in the short term – they will also hit the competitiveness of the Greek economy and threaten to undo the gains that have been made in this area in recent years.

Though both the German and Greek governments are saying they do not want Greece to leave the euro, the possibility of this occurring is now very real as the halving of the prices in Greek bank shares since Syriza’s victory is indicating (Greek banks would be immediately bankrupt should they lose the liquidity support of the ECB). Many Germans are now quite prepared to take the risk of another eurozone crisis should Greece leave the single currency, and in domestic political terms, Merkel has little in the way of compromises that she can offer. Until quite recently Syriza was calling for Greece to leave the single currency, but in recent months softened their rhetoric as polls show that three-quarters of Greeks wish to remain in the euro. Being effectively thrown out of the euro by the EU for standing up for Greek interests may well be seen by many in Syriza as a good outcome.

The last week has seen each side harden their positions. Whilst the history of the EU tends to be one of finding the minimum necessary compromise at the last possible minute, the philosophical differences between the German and Greek governments are ultimately not reconcilable and one or both of them will have to give way on key points of principle for Greece to remain in the single currency.

The Greek New Year

While Europe relaxed during their Christmas holidays, Greek MPs were unable to elect a new President and a general election has been called for January 25. The opinion polls show Syriza the radical left party with a 3% lead. The Greek parliament has 300 MPs, 250 of whom are elected on a proportional representation basis, but the other 50 are awarded to the party which wins the greatest share of the vote.

In recent weeks Syriza have been toning down their aggressive rhetoric about unilaterally defaulting on Greek government debt, possibly in a bid to gain more moderate votes. In addition if the current polls are correct, Syriza will not achieve a majority of 151 MPs and will thus need to enter into a coalition with a more moderate party. Markets have thus become a little more hopeful another Greek financial crisis will be avoided.

Syriza’s economic policy has 3 strands:

  • A restructuring or forgiveness of much of the €370bn debt owed by the Greek government
  • An end to the austerity measures,  an end to the Troika (the IMF, ECB and EU) oversight of Greek economic policy and increases in wages, pensions and benefits throughout Greece, and

3)      Remaining in the euro

The first could be easily conceded on pragmatic grounds. 80% of the debt is owed to the Troika and it is generally accepted that most of it is unlikely to ever be repaid. However politically, any formal restructuring agreement would set a precedent that Ireland and Portugal might be keen to emulate, and thus be unappealing to the Troika (and Germany in particular who have effective veto power here).

The second and third demands are, however,  not acceptable (to the Troika) as a pair. If Greece wishes to remain in the euro (and polls show over 70% of Greeks wish to stay in the euro) then limits to government spending and deficits are part of what is required of all countries.

In recent days senior German politicians have made it clear that they would not be unhappy if Greece decides to leave the euro. Documents from the 2010-11 crisis that have recently become public show that many in Germany would have been quite happy not to rescue Greece and force it out of the euro then, but it was Angela Merkel that ultimately decided the contagion risks of a Greek exit were too high. This time around the contagion risks are generally believed to be very much lower and that the Eurozone could let Greece go without a wider crisis.

So the end of January and early February are likely to see negotiations to form a Syriza-led government and the end of the March is the deadline by which a new agreement with the Troika over Greek austerity is due. Either Syriza or the Germans will have to blink first!

Beware of Greeks bearing unwelcome gifts this Christmas

2015 could begin with bad news from Greece. The governing coalition has put forward a candidate for the Greek presidency, and has said that if he is not approved by the end of 2014 then they will call a general election. For the last few months the Greek opinion polls show the Syriza party as likely to win any general election. Syriza’s major policy proposal is to call on the rest of Europe to “restructure” or forgive a large part of the money that Europe has lent to Greece. They are threatening that should this not be forthcoming, then they will unilaterally default on their debt, threatening another financial crisis in the Eurozone.

The process for selecting a president is that a candidate must win two-thirds of MPs support – this is 200 out of the 300 Greek MPs, on either a first or a second vote. On a third vote, only 60% support or 180 MPs is sufficient. On Tuesday, on the second vote, the governing coalition achieved 168 votes, essentially just the votes of the parties in the coalition and little support from other parties. The third vote is on December 29. It is not at all clear that 12 more votes can be found for the government’s candidate.

So a New Year election is a distinct possibility. A Syriza victory is also a distinct possibility although it is expected that EC leaders will make speeches making it very clear to the Greek people that a Syriza vote is a vote for chaos. There is little support, particularly from Northern European countries, for the idea of writing off loans to Greece, though Portugal and Ireland will be watching with keen interest, having also borrowed heavily in the wake of the Eurozone crisis.  Syriza would though like to remain in the euro – in effect retaining the asset of the euro membership but losing all the liabilities from their debts. Cakes and eating come to mind!

From a Greek perspective, now would actually be a very good time to default on past debt. After years of savage austerity, the Greek budget is now just in surplus before accounting for debt interest or the repayment of debt. This means that Greece no longer needs to borrow money from anyone to fund itself, and so its level of debt is near a peak. Defaulting now has lots of upside and limited downside from this perspective.

The German word for debt is has very close links with the word for guilt, and Germans would regard a Eurozone country defaulting on its debt as profoundly wrong, threatening the very sanctity of the single currency. There would be a strong move to have Greece ejected from the euro, though there is no legal process for any country to leave the euro.

While the world enjoys its Christmas and New Year holidays, Greek MPs will be determining whether we return to our desks to find a new crisis threatening the Euro.

A Stagnant Europe

The outlook for returns from European shares for the next few years is not exciting, though the level of dividend yields is likely to support current prices, thereby limiting the downside risk in these markets.   The investment implications are to remain VERY LIGHT in European equities, where domestic growth is expected to be disappointing and exports outside of the Eurozone are likely to remain under pressure from a strong Euro.

As in the US market, the earnings growth in the Eurozone for 2014 (that is already expected by analysts) is strong, despite the lack of revenue growth expected from most companies. Further, again as in the US, the valuations on these optimistic earnings forecasts are at the high end of the normal range. Core European bond yields are likely to remain low but risks certainly remain in peripheral bond markets.   Political developments need to be monitored closely for any indications that the rise of the anti-EU factions in the peripheral countries begins to change the current support within them to stay in the Euro.

The EU parliamentary elections – According to the opinion polls, the anti-EU, UK Independence Party (UKIP) could emerge with the most votes in the UK’s forthcoming elections to the European Parliament. This apparent rise in nationalist sentiment is not just a UK phenomenon, with the French National Front, Italy’s Forza Italia, Greece’s Golden Dawn, and the Freedom parties in Holland and Austria all scoring highly in opinion polls. Though these disparate parties do not all get on with each other, it is possible that they could, between them, win about 20% of the seats in the new Parliament. This is not likely to be enough to change the path towards greater integration within Europe, but is enough to be a very vocal nuisance within European politics.

Austerity – The peripheral economies (generally understood to be Spain, Portugal, Greece, Cyprus and Italy) have undergone harsh austerity in recent years, leading to very high levels of unemployment (and youth unemployment in particular), in the cause of remaining in the Euro and receiving support from EU bailouts and the ECB. It is perhaps surprising that anti-EU sentiment is not even greater in these countries, but there appears to be a grudging acceptance that the German-prescribed policies of economic orthodoxy must be adopted. These are (i) lower government spending and (ii) smaller budget deficits together with (iii) lower wage levels to regain competitiveness. The stark alternative for these economies is to come out of the Euro and allow currency depreciation to ease their problems, by creating inflation and reducing living standards. Even France, led by a Socialist president, has now succumbed to German orthodoxy on its budget, acknowledging that its levels of taxation and budget deficit cannot be allowed to go any higher, and that spending cuts are necessary.

There are however, two problems with extending the German approach to economic policy to the whole of the Eurozone. First, most of the Eurozone’s exports are to other Eurozone countries, so reducing domestic demand through austerity in one part of the Eurozone merely reduces export demand for the rest of the Eurozone. Second, the peripheral countries’ greatest need is to regain competitiveness against Germany. This would be much easier to achieve if Germany were prepared to become a little less competitive, by having some price and wage inflation. A few years of German inflation at 4% with 0% inflation in the periphery would ease the Eurozone’s problems considerably. However, if German inflation remains at 2%, then inflation at –2% might be required in the periphery; economically such deflation is particularly harmful, keeping unemployment and budget deficits high.   There are few signs that Germany would be prepared to tolerate a 4% inflation rate.

Following the Japanese – The Eurozone is currently edging towards deflation, with the current inflation rate at 0.8%. With its other issues of ageing populations, high levels of government debt and high welfare spending, it shares many similarities with the Japanese economy of a decade ago. There, the economy has, until very recently, been mired in a long period of economic stagnation in which the nominal size of the economy has not changed – there has been some real growth, but this has been offset by falling prices and wages.

Stagnation – Our concern is very much that the Eurozone, following orthodox German policies, with an absence of stimulus from fiscal policy or from monetary policy and with an ECB extremely reluctant to implement QE, may have entered a period of structural economic stagnation, with high levels of unemployment, similar to the experience of Japan. This would be negative for economic activity and indeed for social cohesion in the weaker economies, and, in time, the support for the anti-EU parties may be strong enough to lead to more radical change than the forthcoming elections are likely to create. This might mean a change to policies that were incompatible with continued membership of the Euro.

Just as the UK’s exit from the Exchange Rate Mechanism in 1992 and sharp fall in Sterling marked the start of a new period of growth in the economy and a new bull market in stocks, any country that did exit the Euro would be likely to derive the same benefits. However, for now, continued adherence to the orthodoxy of German economic policy ideas is expected to lead to a period of economic stagnation for the Eurozone economy.

The German dilemma

Since the drama of the Italian election in the spring, European politics have been remarkably quiet.  This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22.  There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.

In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government.  What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.

Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives.  It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets.  Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.

To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default,  in return for a commitment to continued austerity at an agreed pace.  This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency.  It delivers the “stability” that is so prized by German politicians.  However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability.  It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come.  It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.

To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary  banking, fiscal and political unions to go alongside and support the existing monetary union.  At an aggregate level the economy of the Eurozone does not have great budget and trade deficits.  It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.

Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels.  The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective.  The third is very complicated to achieve – in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum.  It would also probably require referenda in several other Eurozone states.  This is though the most logical solution to the Eurozone’s problems.

The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending.  The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.

The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy.  We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.

Eur-out

For the last quarter of a century, Germany has been open to monetary union with the rest of Europe, provided that three conditions were satisfied.  These are (i) no bailouts of other countries who were also in such a monetary union, (ii) the Central Bank that sat at the centre of this union was heavily modelled on the Bundesbank and its operation of monetary policy and (iii) all participating were subject to clear rules with regard to budget deficits and total government debt.  With all three conditions in place, then Germany felt that all other countries in the monetary union would be forced to manage their economies in the same way that the German economy was managed.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.