Global Investing

Euro exit-ology

Whether or not it’s likely or even a good idea, talk of Greece leaving the euro is no longer taboo in either financial or political circles.  What is more, anxiety over the future of the  single currency has reached such a pitch since the infection of the giant Italian bond market that there are many investors talking openly of an unraveling of the entire bloc. But against such an amplified “tail risk”,  it’s remarkable how stable world financial markets have been over the past few turbulent weeks — at least outside the ailing sovereign debt markets in question.

Yet, focussing on the possible consequences for Greece of bankruptcy and euro exit has now become an inevitable part of investment reseach and analysis. In a note to clients on Tuesday entitled “Breaking Up is Hard to Do“, Bank of New York Mellon strategist Simon Derrick sketched some of the issues.

One issue he pointed out,  and one raised in the September Spiegel online report, was the chance of invoking Article 143 of the Treaty on the Functioning of the European Union, which permits certain countries to “take protective measures” and which could be used to allow restrictions on the movement of capital in order to prevent a flight of capital abroad.

Derrick then went through six potentially dramatic features surrounding a sudden euro exit by Greece and likely collapse — temporary or otherwise — of any new “drachma”. 1) Extended market closure surrounding the announcement 2) Capital controls and possible travel bans to prevent a run on banks 3) Instant bankruptcy and default for many Greek companies and households with euro-denominated debts and need for a massive support operation for the private sector  4) a need for temporary banknotes and possible “overstamping” of existing notes 5) need for a balanced budget in the absence of EU support or capital market borrowing 6) reintroduction of price controls to cap soaring inflation.

And it’s perhaps because this relatively conservative list of consequences is so scary that the wider financial world remains so relatively calm. Despite the elevated risks of euro breakup, very few people really think it will happen as long as it remains a “choice” for the governments in question.

Trash heap for sovereign CDS?

For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies. In short, the agreement reached in Brussels last night outlined a haircut on Greek government bonds of some 50 percent as a way to keep the country’s debt mountain sustainable over time. But anyone who had bought default insurance on the debt in the form of CDS would not get compensated as long as the “restructuring” was voluntary, or so says a top lawyer for the International Swaps and Derivatives Association — the arbiter of CDS contracts.

ISDA general counsel  David Geen said there would be no change in the ruling to account for the size of the haircut:

As far we can see it’s still a voluntary arrangement and therefore we are in the same position as we were with the 21 percent when that was agreed (in July)

Is end-game approaching for Turkey’s policy experiment?

In less than two months, Turkey will mark the first anniversary of the start of an unusual monetary policy experiment, and it may well do so by calling it off.  The experiment hinged on cutting interest rates while raising banks’ reserve ratio requirements, and as recently as August, the central bank was hoping  it would be able to slow a local credit boom a bit but still protect exports by keeping the currency cheap.  Instead, an investor exodus from emerging markets has put the lira to the sword, fuelling at one point a 20 percent collapse in its value against the dollar.  That has forced the central bank to roll back some of the reserve ratio hikes and last week it jacked up overnight lending rates in an attempt to boost the currency. It has also sold vast quantities of dollars and is promising  to unveil more  measures on Wednesday.

But what the market really wants to see is an increase in Turkey’s main interest rate.  ”Not sure that ‘measures’ short of rate hikes will help,” RBS analyst Tim Ash writes.

Given Turkey’s massive current account deficit of almost 10 percent of GDP, an interest rate of 5.75 percent will provide little protection to the lira if emerging markets come under serious pressure again. Even if the lira stabilises at current levels, an inflation spike to double-digits looks inevitable.  Meanwhile the central bank’s hard currency reserves are vanishing at an alarming rate — just last week it spent $2.7 billion. That’s a lot given Turkish reserves are just $86 billion, or  four months of imports.  Current central bank policy is  ”an open door to reserve depletion,” Societe Generale strategist Guillaume Salomon says,  noting that despite the massive dollar sales,  the lira is not far off record lows hit earlier this month.

from MacroScope:

Dramatic ending to Greek tragedy

Greece is in the danger zone. Even as the country's finance minister sought to reassure his euro zone counterparts at a meeting in Poland, Greek credit default swaps were pricing in a more than 90 percent chance of default, according to Reuters calculations of Markit data. Economists in a Reuters poll see a 65 percent chance of that happening, probably within a year.

Such fears recently sent jitters across financial markets, prompting some words of comfort from German Chancellor Angela Merkel and French President Nicolas Sarkozy that they are determined to keep Greece in the euro zone. But speculation is growing that Greece will default, and that it will be a messy ordeal. Here are some of the potential dangers if it occurs:

* Greece may be seen as setting a precedent for Portugal and Ireland, analysts said. Yields on peripheral euro zone debt could surge rapidly, making funding costs increasingly unsustainable as yields on Italian and Spanish 10-year bonds surge back towards 7 percent. The ECB could have to intervene more aggressively in the secondary bond market to the detriment of its balance sheet.

from MacroScope:

New twist in Hungary’s Swiss debt saga. Banks beware.

A fresh twist in Hungary's Swiss franc debt saga. The ruling party, Fidesz, is proposing to offer mortgage holders the opportunity to repay their franc-denominated loans in one fell swoop at an exchange rate to be  fixed well below the market rate.  This is a deviation from the existing plan, agreed in June, which allows households to repay mortgage installments at a fixed rate of 180 forints per Swiss franc (well below the current 230 rate). Households would repay the difference, with interest, after 2015.

If this step is implemented and many loan holders take up the offer, it would be terrible news for Hungary's banks. The biggest local lender OTP could face a loss of $2 billion forints, analysts at Budapest-based brokerage Equilor calculate.  Not surprisingly, OTP shares plunged 10 percent on Friday after the news, forcing regulators to suspend trade in the stock. Shares in another bank FHB are down 8 percent.

But Fidesz' message is unequivocal.  "The financial consequences should be borne by the banks,"  Janos Lazar, the Fidesz official behind the plan says. The government is to debate the proposal on Sunday.

Too much correlation

Globalisation is evident in this graphic put together by James Bristow, a global equities portfolio manager at BlackRock. It shows the correlation between the U.S. S&P stock index and counterparts in Europe, Australasia and the Far East.

Basically, what happens these days on Wall Street is matched everywhere else, or vice versa.

It is a bit of a problem for long-term investors. One of the best ways to diversify used to be to buy outside your domestic market. Not so now. This is likely to push more institutional investors to non-correlated assets and hedge funds.

Sell in May and go away?

“Sell in May and go away” — a strategy that implies that taking a good summer holiday is the best way to deliver returns — may seem like an out-dated axiom by which to manage a share portfolio, but research from S&P indicates that using a strategy this decade would have paid dividends.

Analysing the monthly performance of 16 European markets over the 10 year period from January 2000 to December 2009, S&P shows that the summer months are inauspicious for investing.RTXFFP2_Comp

Germany saw an average total return 0f 3.3 percent over the January to May period compared with an average loss of 1.4 percent over the June to August summer months, and a total return of 8.9 percent for the year as a whole, S&P says.

Eight days could point to a correction

Morgan Stanley has been crunching some numbers about Europe and come up with something that (not surprisingly) fits their scenario of  a near-term stock correction but only within a longer-term cyclical bull market for equities. It all comes down to eight days in March, apparently.

Here is the gist:

During 8 days in March, MSCI Europe was up (more than) 50 percent year-on-year.  This is a rare event, has happened on only 80 individual days since 1919.  It is a bullish signal on a 12-month view, a cautious signal on a 6-month view.  On average, the next 12 months  the market has been up 10 percent, up 96 percent of the time, the next 6 months down 4 percent, down 77 percent of the time

As for timing of the correction, MS says it will be when good economic news becomes bad market news sometime in Q2. That is to say, when a string of positive economic data prompts  central banks into a policy reaction or when markets react by sending bond yields and inflation expectations up.

Do southern Europeans know something?

Slightly strange data from Deutsche Börse. Its latest survey of what top European executives have been doing shows increasing signs of optimism.  That is, management board and supervisory board members and their families have been buying shares in their own companies.

All well and good. But the strangeness kicks in when it becomes apparent that a lot of this buying has been done by the top people in the south.  Of 10 companies listed for the largest insider buying, seven were from southern Europe. Of the top sells,  seven were from more northern climes.

Deutsche Börse notes this — “After Spain posted high purchase volumes last month (January), Italy has now awakened from hibernation” — but gives no particular guidance.

Can the euro zone survive Greece?

Wolfgang Munchau, co-founder and president of Eurointelligence, has raised an uncomfortable prospect for investors in Greece. In a Financial Times column today, the long-time Europe commentator argues that Brussels may not be willing to bail Greece out if it were to default on its debt à la all-but sovereign Dubai World is about to.

The EU’s authorities, rightly or wrongly, are more afraid of the moral hazard of a bail-out than the possible spillover effect of a hypothetical Greek default to other eurozone countries. If faced with a choice between preserving the integrity of the stability pact and the integrity of Greece, they are currently minded to choose the former.

Munchau reckons that outright default is unlikely, but wonders whether the current spread between Greek and benchmark German bonds really reflects the risk that investors are taking.  It is currently around 178 basis points after recovering from a blow out on Dubai worries last week.