If a deal is done in the wake of a “Yes” vote, is that the end of the story? Surely it is not. Given Greece’s recent history there will be an implementation risk for any additional reforms that are agreed. There is little chance of Greece being able to tap the capital markets in the foreseeable future so there could be recurring episodes of negotiating consecutive bail-outs for years to come. Who is not to say Tsipras and Varoufakis won’t get another mandate in the future and we go through another drama of brinkmanship? To me, Europe has an obligation to make things more stable. It has to deliver on the promise of membership of the euro being irrevocable. That means further integration, a strong fiscal governance framework, more mutual fiscal funding, and, the greatest challenge of all, greater political unification. Only then can we see risk premiums being reduced to the same levels that were achieved during the euphoria of the early years of the euro. Only then can we put to bed periodic sovereign crises. Europe is big enough and strong enough to deal with any individual countries debt problems and the aggregate debt/GDP level is more comfortable than in the US. In reality, we have looked for this political progress for years. The financial architecture of the euro area is stronger, but it is not clear that we can say this about the political architecture.
Risk-absence for the summer
So, what of markets? The Greek drama has not caused any significant reversal of the increase in core bond yields that defined fixed income market performance in Q2. The benchmark 10-year German Bund yield is still above 80 basis points, only down marginally from the 1.0% reached a month ago. Credit spreads are higher, but only back to early 2014 levels. Equity indices are down from their April peaks, but core European indices are up 13% year-to-date. Italian bond spreads are higher than they were when Quantitative Easing (QE) started but lower than they were a year ago. I think all of this reflects investor views on the fact that Europe is stronger and even if there is a bout of post-Greece volatility, there will be opportunities to buy into risky assets. If Italian and Spanish bond spreads move above 200 basis points then there will be investors re-entering long positions in those assets on the view that the ECB is still going to provide a huge level of support for the bond markets and the banking system. We will see. It’s one of those weekends and Monday morning will see markets move one way or the other.
And then, Washington
Looking beyond Greece, the Federal Reserve (Fed) is looming on the horizon. This is more important for global markets. The Fed sets the tone for pricing financial assets. In the wake of Lehman, the collapse in US bond yields was prompted by aggressive Fed easing. A normalisation of US interest rates from Q3 onwards – to say 2% over the next year or so – will raise the average level of bond yields globally. Treasury yields will rise because a flat curve between the Fed Funds and 10-year bonds is not appropriate for the state of the US economy today. Yields of 3.0% for longer term bonds will be more appropriate. This creates some re-pricing of bond assets and could have an impact on credit spreads as well as government bond yields in other markets. There will be plenty of time to talk about the Fed and adjust investment positions as the communication from Washington becomes clearer on the Fed’s intentions. The baseline is that the Fed moves gradually, reflecting the fact that inflation remains low (even though it is clearly picking up) and that the current Fed is dovish and not confident about how the economy will respond to higher rates and yields. There are clear risks here. One is that inflation might accelerate further, pushing the Fed into more decisive action and leading to a more rapid adjustment in longer term rates. The other risk is around how the markets will react. The Fed has not raised rates for nine years. There are people making trading and investment decisions that have never experienced a monetary tightening cycle. Oh, and I shouldn’t neglect to mention that, at least in bonds, there is no liquidity in the markets.
Should have gone to Mallorca
Many of you will be heading off on summer vacations in the weeks ahead. Much can still happen around Greece in the next few days and weeks. Personally I hope things stabilize before 1 August. Professionally I hope Europe can move on from these intense and aggressive negotiations because there are lots of other issues on the European economic and political scene that demand the attention of our leaders. Behind the noise, the macro environment is getting stronger. This needs to be fostered and investors need to be confident that it is durable. The advice I have taken regarding my holiday in Greece is to hold lots of cash. I recommend the same thing for investors in the short term because volatility in the weeks ahead is likely to create value opportunities for credit, high yield and emerging market bond investors that have not been seen in a while.