James Bevan: That “no” vote and US equities

At the weekend market analysts variously predicted that European equities could open down somewhere between 3% and 8%, with the Euro likely weak and friendless, the market pricing a delay to any Fed rate hike until next year, and credit bearing the brunt of market concerns.

The view has been that key is any action by the ECB, and in particular the liquidity they provide, and that although the ‘no’ vote is unwelcome, some argue that ultimately it’s good news and markets were not caught wholly off guard given the lead up. The chances of Grexit are now perhaps 75% given the country is unlikely to be prepared to meet creditor demands and an ugly standoff may result.  20^th July remains the ultimate crunch date as the situation limps along until then.

As to market reaction, banks have progressively reduced exposure to Greece, and therefore systemic risk should not arise, but the periphery is vulnerable, French politics difficult, and European GDP growth now much less assured.

Amusingly, we’ve had stock market historians coming out of the woodwork, identifying that the first recorded default in Greek history occurred in the fourth century B.C. Back then, 13 Greek city states borrowed funds from the Temple of Delos. Most of the borrowers never made good on the loans, and the temple took an 80% loss on its principal. Greece has defaulted on its external sovereign debt obligations at least five previous times in the modern era (1826, 1843, 1860, 1894, and 1932), and of course last week, Greece defaulted on a payment to the IMF, making it the first developed nation to have done so since the founding of the IMF in 1944. This eliminates any possibility of an earlier deal being revived because the IMF will not, under any circumstances, finance a country that is in default to itself.

Bears & More optimistically
Whilst bears are busy arguing that Greece may be about to have the same contagion effects as the Lehman crisis had in 2008, with the ECB having to be recapitalized, European parliaments being asked to fund Greece’s debts and the EU unravelling, more optimistically,

1) Greece has roughly €313bn in sovereign debt plus €16bn in debt guaranteed by the government.

2) The single largest creditor is the European Union via the EFS at €141bn. The ECB comes in at around €27bn. It is true that a total loss on Greek debt would wipe out ECB bank capital. However, central banks are not commercial banks. They can function with one euro of capital.

3) If the value of Greek debt fell to zero, it would boost debt ratios in the Eurozone by just 3 percentage points.

So, on balance this does not look to be another Lehman moment for Europe. But the potential is there for a total collapse of Greece. As one wag put it, the Greeks are hard to fathom having invented both mythology and mathematics.

As a more issue for markets, corporations have been buying back their own shares, going private and decreasing in number by merging and acquiring. The result is a reduction in the number of outstanding shares, creating a world with a shortage of stocks.

As the New York Times put it on 30^th  June, “The number and dollar volume of deals announced in the first half in 2015 have not just surpassed those of last year, which was a healthy one for corporate transactions by any standard. They are also on pace to catch up with 2007, the last year of unbridled merger optimism before the financial crisis quieted Wall Street. Nearly 20,000 deals worth $2.2 trillion have been announced this year as of June 29, according to data from Thomson Reuters. That is about 40 percent higher, in terms of dollar value, than the first half of 2014. And it approached the $2.3 trillion worth of deals announced in the first half of 2007, still remembered as one of the most buoyant times for mergers–just before the first shocks of the global debt crisis hit.”

Here are some other key points from the NYT article:

1) “Much of the consolidation this year has arisen within the worlds of telecommunications and health care, where many of the big players have felt compelled to become even bigger by swallowing up competitors.”

2) “And the biggest American health insurers are circling one another, eager to find a merger partner to help cut costs and bolster their presence in lucrative areas like Medicare. … Adding special urgency to their deliberations is the possibility of being left out, since government regulators are likely to allow only some, not all, efforts among health insurers to combine.”

3) “Deal makers say that as companies have exhausted other ways to drive up their stock prices, such as stock buybacks and special dividends, they have turned to mergers to try to jump-start growth. They have also become more emboldened to take on the risk of a big deal. Investors have rewarded many acquirers by pushing up their stock prices after a transaction is announced.”

4) “And to pay for a deal, companies have made use of both cheap debt, still plentiful seven years after the financial crisis, and rising stock valuations that have made them more comfortable using some of their shares.”

Stock shortage
Last February, Barrons observed: “These days, there’s a lot less stock in our stock market. It isn’t just because the pool of outstanding shares has shrunk as companies buy back record amounts of their stock, and the era of banks issuing gobs of shares to raise capital has receded firmly into the past. The number of publicly listed U.S. stocks available to investors also is plumbing new lows, even as their prices brave new highs. At the end of January, the not-so-aptly named Wilshire 5000 Total Market Index contained just 3,666 stocks–down from 7,562 in the summer of 1998.”

With so many companies merging and acquiring, investors are finding it harder to get as much exposure to some industries as they could before. Years ago, investors who wanted to invest in computer hardware, for instance, had numerous options. Now, there are just a few major players, such as Apple and Hewlett-Packard. It’s the same story in the airline and health insurance industries – and according to the Fed’s Flow of Funds Accounts, nonfinancial corporations’ net new issuance of stocks totalled -$398bn over the past four quarters through Q12015. Since Q1 2009, net new issuance was a staggering -$2.0tn as buybacks significantly exceeded gross stock issuance. Over the same period, nonfinancial corporate bonds outstanding rose $1.5tn to a record $4.5tn.

Low supply is supportive of share prices – just as new issuance can often spell the end of a bull phase. Equally, so long as companies see other companies as cheap, markets get a helping hand.

Last thoughts on Greece
Whilst on the face of it the ‘no’ vote is bad news, Euroland’s leaders’ initial reactions do not chime with many of the pre-referendum warnings. Contrary to comments that the referendum was a choice between the euro and the drachma, most politicians have signalled a willingness to go back to the negotiating table. The Greek reaction also shows some promise, with Mr. Tsipras wanting a cross-party agreement on the negotiating position, and Mr. Varoufakis’s resignation showing at least some willingness to work with the creditors.

This means that a lot of focus over the next few days will be on how each side can reach a compromise when they are constrained by strong domestic forces from conceding. Arguably the reforms that Mr. Tsipras accepted last week (which Europe rejected) could form the basis for a deal.

Meanwhile, the way forward and what happens next are still in Greek hands. There is no legal basis for ejecting a country from the euro. For sure, creditors, particularly the ECB, could be sufficiently horrid to Greece such that leaving the euro is considered a less-bad option than trying to remain – but it is still a decision for the Greek government.

As a backcloth, the Greek people seemingly still want the euro, with polls suggesting that between 70% and 80% want to keep the euro ‘at all costs’. It’s hard to say where this support founders, and if the banking collapse means a significant bail-in of normal Greeks’ savings, then their incentive for remaining in the euro would decrease. In this sense, there is a race against time – how quickly can they reach a deal – and how hawkish will be the ECB’s reaction.

As part of the way forward, another vote of some sort is not out of the question. Any deal reached may be passed by the parliament, but Mr. Tsipras’s future would continue to be questioned and his party could split. Alternatively, there could be new elections or possibly another referendum if Grexit looked to be inevitable. If the question was worded as a stark choice between staying in and leaving the eurozone, a positive outcome could still be more likely.

Questions
There are than a number of key questions that we need to focus on in the longer-term in order to assess the impact of the No Vote.

First, the relationship between debtors and creditors, and we need to watch the French and German negotiating positions and how they evolve. France  is  less  of  a  creditor  than  Germany and  may  take  a different approach in terms of what happens next, and if Greece disrupts the Franco-German position, then that could be potentially very serious.

Secondly, there’s the question as to what the US does. Greece is a NATO member and could create all manner of mischief if it were to leave EU/euro, and it’ll be interesting to see how much pressure that puts on Mrs. Merkel to find a solution.

Thirdly, there is the global economic context. This may well determine how much fallout/contagion we get. During previous euro crises, sovereign spreads came under more pressure when the global economy was weakening. If global growth disappoints in the second half of this year, that raises the risk of contagion.

Fourthly, we don’t know how bad things would have to get before the Greeks actually want to leave the euro. The lack of a functioning banking system is a bad start and we need more clarity from the EU on how long Greece can be in default – and to whom. Thus we just don’t know if Greece be in default to the ECB and still stay in the euro. 20^th July is key in this regard.

Fifthly, we can wonder if the euro group will improve their offer to Greece. Much of the language coming from the core of the euro group suggests no, but there may be circumstances that cause that to change.

Sixthly, we can worry that there may be an existential risk to the euro itself.

Macro confidence
From a macro-economic perspective, it’s very difficult to estimate the impact of what’s going on with any confidence. With Grexit, were this to happen, there could be as much as a one to two percentage point hit to global growth over the coming 18 months, but the range of possibilities is large. It could be as small as ½ percentage point, but unlikely to be as large as the 5 percentage points seen with the Lehman Bros shock.

The mechanisms that we’ll need to monitor are direct links to the Greek economy which are generally quite small (Greece is less than 2% of Euroland GDP and barely 1% of EU28 GDP), and financial exposures (bank exposures have fallen to less than US$50bn and Greece’s total private external debt, including banks’ exposures, is probably only around $125bn, down from more than $200bn a few years ago).

The main direct link is via government exposures: the scale of government loans to Greece, totalling €246bn; exposures via the Target2 system i.e. their indirect exposures through national central banks, add another €100bn. But indirect links are harder to quantify and there are three potential channels of contagion: a rise in Euro-risk premiums and a negative impact on financial market liquidity as risk of a Greek exit alters the perception of irreversibility of the euro; a rise in economic uncertainty, particularly in other ‘peripheral’ Euroland economies;   reducing   the   potential   for   investment spending; and increased political risk, with Spain and Portugal facing elections later this year.

Impact & ECB
There is also the economic impact on Greece itself. While the hit to the Greek economy would probably be smaller now than it would’ve been two or three years ago, we can suspect it would still be significantly disruptive. The big benefit to Greece would come from ridding itself from its debt burden, but the cost of defaulting on those debts, at least in the short term, would be to shut Greece out of external funding markets and quite possibly bankrupting its banking system.

As previously discussed, we should doubt the argument that Greece would benefit from a devaluation after leaving the euro. Greece’s competitiveness problems extend beyond  an  issue  of  excessive  labour  costs  and  concern  the efficiency  of many  of its  economic  institutions (judicial  system, public administration, tax collection etc). For Greece to benefit in the long run, the government would have to make a series of very sensible economic decisions/reforms at a time of severe economic disruption.

In thinking about the issues, the stance of the ECB is key. The ECB governing council meets to review its ELA with Greek banks. We can expect the ECB to keep the existing €89bn ceiling and the Central Bank of Greece has requested a shift up in the ELA ceiling. But the ECB could decide to apply a bigger discount to Greek banks’ collateral, essentially forcing Greek banks to pledge additional collateral or pay back some ELA loans. This could force the Greek government to further limit daily cash withdrawals to protect banks’ liquidity. The ECB could also ask the European Council, as it did in 2012, to guarantee Greek bonds that banks use as collateral in return for ELA funding, essentially ensuring that the decision to let Greece go or not is taken by European head of states. They have until July 20^th to find a solution, when €3.5bn worth of Greek bonds held at the ECB mature. Default would most likely force the ECB to withdraw its ELA assistance to banks, cutting all access to central bank money, potentially increasing pressure for Grexit.

Currency
On the currency front, the only certainty is that volatility will remain high. EUR/USD was marked lower overnight, and negatives for the euro include expectations of more (/frontloaded) ECB QE; and investor reassessment of stability of currency union (with elections later this year in Spain), but there are potential positives for the euro too. These include whether the Fed will now postpone any hike it was planning this year, and whilst the euro would have a higher ‘fair value’ equilibrium if its weakest member left.

Turning to equities, the likely challenge looks to be the  lack  of  policy  certainty  and  the  drawn  out  nature  of negotiations. These could conspire to drive markets lower though the second half, and markets only stabilizing once yields are high enough to provide an increased risk premium over core-Euroland bonds.

If there was a rapid move to Grexit, this would likely be unambiguously bad for Euroland equities. But by way of background, before today Euroland equities were already 8% off their April peaks and only fell 15% in 2010 when Greece first fell from grace, and Greek 10 year yields rose from 6% to 12%. However, as the clarity of the policy position increases this should allow markets to move towards a new equilibrium quite rapidly, perhaps with the euro regaining composure following ECB action and reassurance from   policy makers that a more “Germanic” Euroland would be a better Euroland.

Nevertheless, and not to beat about the bush, the ‘no’ vote will not have helped either the outlook for Euroland or global economic growth, or created greater policy certainty.  Such conditions can typically be expected to give rise to higher Equity Risk Premia, thereby depressing equity pricing, and to favour more defensive equity markets and quality stocks. One important question is whether the total declines from early April will stabilize in the 10%-15% range (as they did in 2010 and 2012) or whether markets may drop closer to the 20% that  was  seen  in  2011, in  part  as the global  slowdown helped to intensify worries about debt sustainability, undermining investor confidence. In this context, recent Chinese developments represent another market challenge, and eventually small straws can break camels’ backs.

With the uncertainties in Euroland, the outlook for equities looks relatively negative in the short-term, and within equities, we maintain a defensive stance both in terms of countries (largely avoiding the periphery) and sectors. We anticipate that we can look for equity market recovery when the global economy stabilizes and policy is seen to remove existential risks to the euro.

In practice, in uncertain times, yield support can be a comfort: but hard cash is better than promises and higher yields have to be stress-tested, with ‘quality’ being a well-known way of checking on the credibility of free cash flow yields. Meanwhile, low bond yields favour low beta and ‘low vol’ stocks, with ‘Growth’ outperforming ‘Value’ as yields have fallen. Interestingly this is driven by valuation measures (especially P/BV) rather than growth factors – and we anticipate that investors should be cautious about stocks on low valuations, given that many such opportunities are cheap for a reason.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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