Inside investment: Solon(g). And good riddance
Grexit or not, the selective default of Greece has already changed everything for both bond and equity investors in Europe.
At school I used to wonder how any language could imbue the word "the" with so much meaning that it required 24 variants on the "the" theme. Such were the joys of learning classical Greek. One of the other things vaguely recalled from those distant times were the reforms of Solon, one of the last Athenian archons. He enacted the seisachtheia, which cancelled all debts that involved enslavement.
Now an entire nation finds itself in vassalage to the Troika (European Central Bank, European Union and IMF) it might be time for a new Solon, Alexis Tsipras perhaps. Many think this will portend disaster. The first horseman to appear will be contagion. The yield on the bonds of the other peripherals will gap wider, making their debt burdens unsustainable and plunging them into a depression and deflation spiral and towards the eurozone exit. Next galloping over the horizon comes a banking crisis, with the European financial system hobbled by its exposure to peripheral debt and unable to function. Political instability and civil unrest inevitably follow.
The doomsayers are probably wrong. A Greek exit from the eurozone has been so long telegraphed that banks, investors and policymakers will be prepared. Behind the scenes the ECB will already have a mandate to inflate its balance sheet and buy as much Italian and Spanish debt as necessary. Bank recapitalizations via an expanded European Stability Mechanism would follow and an announcement of the creation of joint and severally liable euro eurobonds, as suggested by the German Council of Economic Experts, is possible.
There are ›more than enough policy tools to make a Greece exit containable and there is far too much political capital invested in the euro project to allow it to matter. Sadly, for the Greeks it never really has. That is not true of Spain and Italy. You do not need a PhD in economics to grasp this. A basic knowledge of geography will suffice. Greece is small and on the southeastern fringe of Europe. Spain and Italy border France and you can get from Munich to Milan via the Brenner Pass in about four hours.
For investors, however, Greece has already changed everything. The manner of the Greek PSI (private-sector involvement) established two bad precedents. First, private-sector involvement was accompanied by public-sector detachment and seeming indifference. The ECB and European Investment Bank subordinated investors. Secondly, credit default swaps offered no insurance.
In these circumstances, sovereign risk is no longer a special case. Government bonds are akin to a credit that cannot be hedged and when that happens there are frightening consequences. In a normal recession government bonds are attractive because they are safe assets offering some return. As growth turns down, equities fall with earnings, but government bonds should rally because they are the least-worst asset class. This makes borrowing cheaper and helps the economy to recover.
If government debt is viewed as credit none of these stabilizers function. A recession is a reason to sell bonds because the ability of the sovereign to meet payments has been impaired. This increases the cost of the debt and the likelihood of default. It also sets the linkage between sovereigns and banks in stone. The cost of bank debt becomes a spread over the sovereign. If banks cannot fund themselves, they cannot provide finance to the broader economy.
This mechanism is already at work in the periphery. The investors in Portuguese, Spanish and Italian debt are now overwhelmingly Portuguese, Spanish and Italian banks and insurance companies and official institutions, such as the IMF and the various European bailout mechanisms. In Portugal private-sector investors own less than 15% of the debt. Cross-border trade in peripheral eurozone debt has all but died.
The liabilities of the remaining non-official investors are Portuguese, Spanish and Italian, regardless of the denomination of the currency. These institutions therefore hold a natural hedge against the break-up of the euro. The official institutions do not need to hedge. They can print money and subordinate other investors, as happened in Greece.
Contagion is already the reality. A Greek exit would not make matters worse because there are few marginal buyers or sellers of peripheral debt. Grexit might even set the stage for a spectacular rally on the periphery. If the ECB stepped into the market, every short position would be closed. This would also improve the perception of banks’ solvency.
The reassessment of sovereign risk has also changed equity markets. Fund managers that have structured research teams along sectoral lines are being forced to rethink the comfortable certainty that money flows across borders in a frictionless way and that companies will be priced relative to their industry peers. The German DAX index has outperformed the Euro Stoxx index by 10% this year, the most dramatic divergence since the creation of the euro. Country risk is back.
Whether Greece stays in the euro or leaves after this month’s elections is a matter solely for the Greeks. Austerity fatigue is entirely understandable. In a standard IMF-mandated programme, fiscal discipline would be accompanied by currency devaluation. That is not possible in the euro. There will be horrific volatility in the days following Grexit, but long-term investors should hold their nerve. Heidelberger Druckmaschinen is a tempting stock idea. It makes very fine printing presses.