Licht am Ende des Tunnels?

Light at the End of the Tunnel?
 
Having focused on some worst-case scenarios in recent weeks, it may be appropriate to think about the future. We remain very concerned about Greece, and this is the single largest risk factor affecting our portfolios. However, this is not the same thing at all as saying that we predict a disaster, or contagion. In fact, while we should not ignore the ways by which a Greek repudiation of austerity could have negative effects surpassing the 2008 bankruptcy of Lehman Brothers, this is not the central case. It is not even a very probable case. Much more likely is either some form of agreement, or some form of containment. A number of commentators, including most notably Deutsche Bank’s Thomas Mayer, have outlined a scenario which envisages Greek political frontrunner SYRIZA forming a government and doing exactly what it says it is going to do, which is to repudiate austerity measures. If Germany then does exactly what Finance Minister Wolfgang Schäuble says he will do, then we have the perfectly bad outcome described last week in “Prisoner’s Dilemma” of default, bank runs, and contagion. However, Mayer’s scenario then posits an immediate Eurozone-wide deposit guarantee scheme being introduced, including Greece. In this possible future, Greece never exits the euro. No doubt queues would form at ATMs, but the machines would keep working, as they do in all other Eurozone member states, and the run eventually would fizzle out. For the externally-facing Greek economy–tourism, shipping, agriculture—remittances continue to be made in euros, employees continue to be paid, and the banking system continues to function. Escrow arrangements may be made for bond payments, but the Greek government likely runs out of cash for operating purposes—principally, payment of salaries, pensions and welfare—sometime over the summer. The government then does what Argentina and California have done before it, and issues IOUs. Likely, these would be accepted at least for basic foodstuffs and other essential utilities, but some form of black market exchange would develop, giving these IOUs a value, which would probably be at a deep discount to the face value. By this route, either the IOUs become a new currency, or the disparities in society that would inevitably follow cause Greece’s government to return to austerity and a subsequent bailout makes IOU-holders whole. In either event, the crucial detail is that this IOU “currency” emerges without Greece ever formally repudiating the euro, and with the potentially massive consequences of a formal exit never needing to happen. This may be too optimistic–if that is the right word for a situation where Greece’s state employees could see real wage cuts of 50% but we ask for our readers’ forbearance. This may never happen. It may well be that following the weekend’s communiqué from the G8, the Eurozone’s political leaders will climb down and accept less austerity. Or it may be that a more market-friendly government emerges in Greece once the electorate recognizes that a protest vote can have severe consequences. The point is that we can begin to see ways in which solutions begin to form that do not necessarily start the unraveling of the euro. To a certain degree, at least in aggregate, it may not even matter which of these scenarios unfolds–in a highly synchronized world of “risk-on risk-off” all that market participants may really need is the knowledge that disaster has been averted. That market participants and journalists can now get some comfort with this idea should lead portfolio managers, prudently, to consider emerging from the bunker and surveying the opportunities.

Before rushing headlong into aggressive risky positions, we share two notes of caution. The first is that disaster is, we believe, improbable. That does not mean it is impossible—the risks are still worryingly high, as the Chart of the Week, “Greek Banking Deposit Flight,” should make abundantly clear. The second is that things may still get worse before they get better even in the more optimistic scenarios we have outlined. In fact, most rallies begin with a final “capitulation,” which we have yet to see. Our challenge is to see through that, to the light at the end of the tunnel.

Alex JohnsonCo-Head of Global Fixed IncomeFFTW, a BNP Paribas Investment Partner