The Discreet Charm of the Never Ending Bailouts

Investors should prepare for Greek ‘bail-out III’

By Sushil Wadhwani

At last the tortuous process leading to agreeing a second Greek bail-out deal has ended. The main significance of the deal is that it was agreed. After all, many market participants had begun to fear that it would not be and that Greece would default. Accordingly, some were worrying about the potential consequences of a euro break-up scenario that they believed might have made the Lehman bankruptcy and its aftermath look trivial.

Of course, the deal does not solve Greece’s problems. Thus, it is widely recognised that we will probably be worrying about Greece again later. The analysis conducted by the International Monetary Fund is said to recognise the risks that the necessary competitiveness adjustment could come about via an even deeper and more protracted recession, which could imply that the debt-to-gross domestic product ratio ends up at 160 per cent of GDP in 2020, rather than the 120 per cent for which the programme is aiming. Besides, the process may be “accident-prone”. For example, it is possible that the Greek government that emerges after elections due in April will ask to renegotiate the deal.

Also, if Greece does achieve a primary surplus in the coming years, this would enhance its ability to deviate from the agreement. What does this mean for global equity and bond markets? Given the uncertainties, it is perhaps appropriate to consider scenarios.

On an optimistic view, that a deal was struck implies that neither side was ultimately willing to risk a Greek exit because they recognise that no one fully understands all the ramifications of such a decision. Under this scenario, when pressure again builds, the authorities will do the same: let Greece remain in the euro, even if it fails to keep to its adjustment programme. So, the reality of “bail-out II” means that, if the situation becomes critical, there will be a “bail-out III”.

Under this scenario, equities should outperform bonds significantly. A standard valuation model suggests that stock markets in the US and Europe are inexpensive relative to bonds. Our research into the “equity risk premium” suggests that markets may be assigning a non-trivial probability to a “disaster scenario” for GDP as a result of “euro tail risk”. Hence, a growing belief that neither side would risk a Greek exit should support equity-bond outperformance.

In Europe, even before this week’s Greek deal, tail risks had fallen as optimism grew that the authorities might be winning the war to keep euro together. The ECB’s Longer-Term Refinancing Operation has been a particularly successful means of helping to keep pressures at bay.

In addition, some economists have begun to question if the periphery bond market sell-off last year was overdone – the reverse of what happened pre-crisis, when credit markets had been overly sanguine, and spreads too narrow relative to fundamentals. In the jargon, we have “multiple equilibria”, with recent policy initiatives helping to move us to the better equilibrium.

Another reason for optimism is recent economic data, on both sides of the Atlantic: more data releases have surprised economists on the upside than on the downside.

A second optimistic scenario assumes that, eventually, Greece will exit, but only after policymakers have erected a credible firewall that protects Italy and Spain. On this view, an “orderly” Greek exit no longer holds any horrors for global equities, and the inexpensive relative valuation then implies they do better than bonds.

The rally in equities since October is likely partly driven by the growing belief that a Greek exit will not occur or, even if it does, Italy and others will not be much affected. If events become even more supportive of these beliefs, equities would most likely fare better than bonds. Fixed-income markets, especially, seem to be overly pessimistic about growth prospects.

However, there is a third, pessimistic scenario. It is uncertain, for example, whether European policymakers can build a strong enough firewall. After all, can any of us truly know, before the event, that the forces of contagion may not overwhelm the best-prepared defences?

Besides, there are undoubtedly still very big risks in Europe. The French presidential election on April 22 may lead to policy shifts. Likewise, with the Greek elections in the same month. Either side may still decide a Greek exit is preferable to the alternative. And there are plenty of implementation risks that remain with the second bail-out package. Hence, it seems likely that we are going to have to continue to worry about euro tail risks for some considerable period, even if it is more likely than not that the risk premium assigned to it gradually erodes.