Shamik Dhar, Senior Economist, Investment Strategy Team & Stewart Robertson, Senior Economist, UK and Europe
The Greek election this weekend may prove to be a defining moment for Europe. However, it could result in two very different outcomes. At one extreme, we could see the break-up of the euro area. At the other, we may be heading towards a much closer fiscal and political union.
It is increasingly likely that Greece will either choose to leave the euro zone or be ejected by the other members after refusing to adhere to its austerity programme. If Greece does exit the Eurozone, will it be an orderly departure or a financial and political rout? For investors, the answers to these questions have profound implications for the asset allocations they should adopt and the returns they can expect.
In the attached paper, we have outlined three potential key European scenarios, their probabilities and implications for asset classes:
• No exit: muddling through (40% probability)
Under this scenario, policy makers and Greek politicians pull back from the brink. The International Monetary Fund (IMF) programme is modified in the expectation that Greece will miss its targets in the near future. The markets respond with a relief rally, followed by the flat/volatile markets that have characterised the past two years.
The effect on asset classes: Equities rally by 5-10%, clearing current oversold conditions. Bunds, treasuries and gilts sell off to yield approximately 1.90%, 2% and 2.10% respectively. Meanwhile, Spanish 10-year government bonds rally to yield 6% and Italian 10-year bonds to yield 5.40%. The euro rallies to 1.32 against the USD, clearing recent oversold condition, and the USD, JPY, CHF rally against risk currencies.
• Managed exit (40% probability)
Under this view, the Troika halts disbursement of new funds. Greece runs out of money in June or July and issues IOUs, which become the new drachma. The new drachma declines by 50%, and Greece reneges on its liabilities to the euro system. However, policy makers respond swiftly and decisively to contain contagion with deposit guarantees, another LTRO and an expanded Securities Markets Programme. These measures calm the markets and halt capital flight.
The effect on asset classes: Equities initially fall another 15%, but respond well to the aggressive policy response with a 20-30% rally. Bunds rally to yield 1.20% before selling off, while treasuries and gilts are similarly affected but to a lesser degree. Spanish and Italian 10-year bonds sell off to yield approximately 6.70% and 6.50% respectively. The euro falls to 1.20 against the USD before rallying back to the mid 1.20s.
• Disorderly exit (20% probability)
Policy makers fail to deliver an aggressive response to a Greek exit. Contagion spreads to other peripheral countries, resulting in deposit flight from Greece, Portugal, Spain, Ireland and Italy. Retail deposits of €3.5trn are at risk.
The effect on asset classes: European equities drop 30%, straight through their 2009 lows. Bunds yields rally through 1%, hitting 0.80% with downside risks, while treasuries and gilts yield 1.50% and 1.60% respectively. Spanish 10-year bonds sell off to yield 7.50% to 8.00%. Italian 10-year bonds are similarly at risk. The euro falls to 1.10 against the USD and there is an aggressive sell-off in all risk currencies. The JPY rallies back to 76 vs. USD, and pressure builds on the CHF ceiling vs. EUR as investors pull out of euros.
For investors, the stakes are high, and the extent to which they weather the impending events in Europe – or profit from them – will depend largely on the asset allocation positions they adopt. The range of potential outcomes and their durations is wide. For this reason, we focus on identifying asset allocation positions which have the potential to pay off under a range of different scenarios, and combine these with hedges designed to provide protection in the event of our worst fears being realised.
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