June 29, 2015

“You shouldn’t commit suicide because you’re afraid of death”  European Commission President, Jean-Claude Juncker

Last week, European markets rallied strongly on rumours that the “Troika” (the IMF, the ECB and the European Commission) and the Greek government were close to an agreement to at least postpone the funding issues facing the country. Ahead of tomorrow’s looming debt repayment to the IMF (the Greeks are trying to borrow money from one creditor, its Eurozone counterparts, to repay the debt of another creditor, the IMF! The phrase “rearranging the deckchairs…” springs to mind in this case) a deal appeared to be in place, subject to last details being clarified. The loan sum under discussion is just Euro15bn, with a “gap” in the agreement between both parties amounting to just 0.5% of Greek GDP (or about Euro800mn) in a broader Eurozone of Euro10.5trn. A tiny, almost irrelevant, amount of money within the compositional nature of the proposals from the Troika has been enough to throw the situation into apparent chaos. Very simply, Syriza wants the rich to bear more of the burden in tax increases whilst the Troika seeks a commitment to enforcing prior agreements, firstly, and a blend of tax increases and spending cuts alongside real institutional reform. Unfortunately, previous failure to enforce rigorously much needed structural changes, for example in the area of tax collection, weakens the tolerance of the Troika and lessens the credibility of the Greek negotiators.

The Greek negotiators in Brussels appear to have learned of the intention to call a referendum to allow the Greek people to accept or reject the “final” Troika proposals from the media, whilst Finance Minister Varoufakis stated in his regular Twitter updates that “Capital controls within a monetary union are a contradiction in terms. The Greek government opposes the very concept”. Just hours later banks are closed, deposit withdrawals are limited and the Prime Minister proposes Capital Controls. To say that Greek policy appears uncoordinated would be polite. Furthermore, Varoufakis also said “Democracy deserved a boost in euro-related matters. We just delivered it. Let the people decide. (Funny how radical this concept sounds!)”. The proposition that the Eurozone as a whole answers to the expressed wishes of Greek voters is fanciful in the extreme. No! The Greek government answers to the Greek voters and it appears, when faced with the end-game in the negotiations, to have blinked first and asked the Greek people to take the decision it seems incapable itself of taking. The Greek government expects its negotiating position to be strengthened by a “no” vote in favour rejecting the Troika proposals. We doubt that to be the case.

Local polling in recent days suggests that approximately 70% of Greeks want the country to remain within the Eurozone and, given a brief experience of the uncertainty and fear generated by capital controls and bank closures, we would expect that to be reflected in a clear “yes” vote in favour of compromise and agreement with the Troika. Whilst avoiding an imminent “Grexit” (this would, in any event, take many months in transition and not be an immediate event) it would certainly lead to Greek elections and another period of political uncertainty in the country. Another interim technocrat government may be necessary to manage the country in the intervening period.

Greek anger is understandable, the economy has shrunk 25% and the structural budget balance has swung by an entirely unprecedented 20% of GDP, but “root and branch” institutional reform, which is desperately needed, cannot be avoided and would not be addressed by default, denial and devaluation. The inflation that would, we think inevitably, eventually follow from the reissue and devaluation of a “New Drachma” would represent the most indiscriminate and insidious tax on the poor, since inflation always hurts harder those with the least assets and redistributes wealth and income from the poor to the rich.

We highlighted the geo-political implications of Grexit in our last monthly letter – Greece increasing its economic and political ties to Russia (giving the Russians the possibility of a naval base in the Mediterranean) and a worsening of the European migrant crisis (Greece is already a significant point of entry – 61,000 migrants have arrived by sea so far this year – and a deepening economic crisis would dramatically increase the porosity of European borders). Both parties, the Greek government and the Troika, have little to gain and much to lose from the impasse, so let’s not throw in the towel just yet as European officials have demonstrated over the years their uncanny ability to find ways to postpone making difficult decisions and take advantage of improbable loopholes as well as coming up with questionable legal interpretations to temporarily patch apparently unsolvable situations.

The ECB, as part of its commitment to QE, increased its balance sheet by Euro 207bn in the 4 weeks through April 10th, driving bond yields sharply lower and boosting equity markets, but then took its foot off the pedal and in the last 4 weeks has increased its asset base by just Euro 35bn. In response to the current situation, we would expect the ECB to accelerate the QE process from the recent anaemic pace. The maintenance of systemic liquidity is paramount and the ECB has the scope to prevent contagion.

Our portfolio, given its substantial exposure to US Government bonds, which have rallied sharply on safe haven flows and the lower likelihood in these circumstances of a Fed rate hike, is proving quite resilient in the face of this volatility and uncertainty despite the equity sell-off that is negatively affecting our pro-cyclical exposure.

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