The re-pricing of risk assets for the increased likelihood of a disorderly default by Greece may have run its course. An investor-friendly outcome of the next election is most likely if it is framed as a referendum on Greece remaining in the eurozone.
The adage “sell in May and go away” has been apt this year. The specter of a disorderly Greek default raised anew questions about how the approach to solving the eurozone debt crisis.
Lower policy uncertainty over precisely that question as well as U.S. monetary policy was the main reason we expected 2012 to be a good year for risk assets. It would mean less financial market volatility, which would attract investors back to risk assets.
Instead, we have had near-panic conditions in financial markets. Most people considered the issue of Greek debt closed after the February agreement to write it down.
But Syriza, the party that got the most votes in Greece’s parliamentary election, ran on a platform of defaulting on the debt and reversing the austerity and structural reforms agreed with the troika. Pointedly, the platform also included keeping Greece in the eurozone.
The potential for contagion from a disorderly default is high enough to warrant the re-pricing behind the near panic conditions in financial markets. The most obvious source of contagion is the demonstration effect; a Greek exit from the eurozone is the first step on a slippery slope that ends with a total break-up.
But even ignoring contagion, the cost of a disorderly default to the other eurozone members would be high, “somewhere between catastrophic and Armageddon” to quote the Institute of International Finance (IIF)’s Charles Dallara.
Official creditors hold most of Greece’s debt and their capacity to lend to other needy states — think Spain, which may need official assistance to help recapitalize the banks — would be impaired.
The solvency of the European Central Bank (ECB), which owns 40 billion Euro of Greek bonds and has 140 billion Euros of repos with Greek banks, also could be threatened.
The costs to Greece also would be steep (or they would have defaulted already). ING estimates Greece’s government primary deficit at 2 percent of GDP and its current account deficit at 0.7 percent of GDP.
While not big, these deficits would have to close immediately in the event disbursements of official capital ceased, as they would in a disorderly default scenario. Significant cutbacks in government spending and imports would be unavoidable.
A disorderly default, the worst-case scenario, would be the baseline scenario if Syriza, which emerged as the most popular party after the first election, runs and wins on the platform of rejection or renegotiation of the memorandum, Greece’s commitment to the troika of EU-ECB-IMF.
Continued membership in the eurozone would be untenable and the baseline scenario in this case would include another sharp selloff in the prices of risk assets and renewed panic in financial markets.
We do not consider the worst-case scenario the most likely outcome. Most Greeks, 78 percent according to polls, want to remain in the eurozone. The best-case scenario would see the election framed as a referendum on Greece remaining in the eurozone vs. rejection of the memorandum and Greece leaving the eurozone.
Based on the opinion polls, the pro-eurozone faction should win, in which case a compromise with the troika on softening the conditions in the memorandum seems inevitable. In this scenario the recent re-pricing of risk assets would be reversed.
Another indecisive election result cannot be ruled out. If that happens, however, the re-pricing in financial markets that has already occurred probably obviates another round of the same.
However, elevated uncertainty (and volatility), with the attendant chilling effect on risk-taking, would persist.
Fallout from the near-panic in financial markets has had economic ramifications. The deflationary shock of the flight from risk is evident in market-based measures of expected inflation, plunges in which were a reliable indicator of the quantitative easing or QE1 and QE2 in the U.S.
Rising hopes for QE3 mean increased uncertainty about U.S. monetary policy. Increased uncertainty means higher financial market volatility.
Near-panic will persist in global financial market until the re-pricing for the increased likelihood of a disorderly Greek default has run its course. We think we’re nearly there.
What happens next depends on the Greek election. We suggest investors monitor the success in framing the election as a referendum on continued eurozone membership.