The Weekly Strategy Report (16 February 2015) - J.P. Morgan Asset Management
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The Weekly Strategy Report (16 February 2015)

Contributor Global Multi-Asset Group
Greece on the brink

It was back to the brink stuff last week in Europe, as the negotiations between Greece and the rest of the eurozone ran into difficulties. The bailout talks around a new programme, as demanded by the new Greek government, foundered because the other eurozone countries saw no need to discuss a new programme before the current one had been completed. A meeting of eurozone finance ministers ended in failure in the early hours of Friday, albeit very close to a compromise agreement. Further talks have begun, with an intention to find some common ground. The clock is now ticking towards the end of the month, which is the deadline for Greece to accept the terms of the Troika programme and when some investors believe that Greece could run out of money and be forced to default.

Possible outcomes

It seems that markets have been too relaxed about the prospects for a Greek deal. This is despite the fact that the credit default swap market has been pricing in an excess of an 80% probability of a Greek government default within five years. While several participants have stated that a deal will be done after the initial bout of shadow boxing, there is an underlying view that there has to be a resolution – not least because Greece apparently has little or no bargaining power. There are inconsistent objectives for the Greek government: to obtain debt relief, while remaining in the euro. Opinions polls show that 75% to 80% of Greeks wish to remain in the European Union, though the size of the Syriza vote in the election also indicates a clear preference for debt relief given the party’s mandate. The challenge that remains is to find an outcome that is acceptable to the eurozone governments as well as the Greek people.

It is tempting to classify this situation as one of Donald Rumsfeld’s “known unknowns”, where there things that we do not know. But are there any “unknown unknowns” that we should worry about? Some have drawn parallels with the Lehman bankruptcy in 2009, so it would be wrong to assume that rationality will always prevail.

Considering the worst case

The awkward question is whether there are any advantages in Greece defaulting and leaving the euro. In this respect, historical comparisons with Argentina and Brazil, who abandoned their fixed currencies, may be apposite. The first (common) lesson from the Latin American examples is that considerable political will is needed to stick with a currency board system. The lesson from Argentina was that the process of default, devaluation and recession proved to be counter productive, because there were huge foreign exchange mismatches in the private sector and the banking system. By contrast, Brazil did not have those foreign exchange mismatches, with the result that its exit from a fixed currency proved to be positive for economic growth.

Currently, Greece has moved into primary fiscal surplus (the budget balance excluding debt service), while the current account of the balance of payments has also moved into surplus. Although the primary surplus will have slipped back, as Greek tax collection has slipped amid the recent political uncertainty, it does give the country some potential leverage over its creditors. Moreover, the majority of Greek debt is public debt, which is mainly owed to official creditors, but it is unclear if there are any sizeable FX mismatches. While a default would be the worst-case outcome – and a relatively unlikely one – investors should not assume that it is impossible. Our central case assumes that there will be some agreement, with debt relief being offered in turn for domestic reform.

Deflation and disruptive currency alignments

The Riksbank, Sweden’s central bank, made history last week by being the first central bank in the current cycle to move its official repo rate into negative territory. In addition, it announced the commencement of quantitative easing (QE), amounting to SEK 10 billion, or 1% of GDP. After the announcement the Swedish krona fell vs. the US dollar to the lowest level since April 2009.

On the face of it, it seems a strange decision, given the lack of distress in the Swedish banking system. House prices are rising strongly, fuelled by robust rates of credit growth. Nevertheless, Swedish inflation has been negative for two years, while there is a danger of an excessive demand for cash. This is in contrast to other countries that have announced QE, where usually the credit cycle has been much less robust. However, the Swedish decision probably owes itself to the looming launch of the European Central Bank’s (ECB’s) QE programme that is due to begin in March. In this respect the Riksbank is not alone. Central banks in Switzerland and Denmark have also reacted, with the Danes cutting interest rates four times in the past three weeks, while the Swiss National Bank let the currency appreciate.

These episodes reflect the difficulty of having to manage monetary policy (and central banks’ balance sheets) vs. that of a much larger anchor currency. These difficulties can be compounded when the central bank of the anchor currency aggressively changes monetary policy, as with the ECB. A similar disruption can occur when the central bank of an important trade partner/competitor changes policy sharply – for example, the Bank of Japan has aggressively eased monetary policy, exporting deflationary pressures to China and Korea in particular.

One question asked of your intrepid author when he was on the road recently was where active investors could find asset allocation opportunities over the next few quarters. One answer therefore appears to be in currency markets, where valuations may be reaching extremes.

Chart of the Week

Our Chart of the Week shows absolute deviations of real exchange rates in the G10 group of nations from their five-year averages (a proxy for “fair value”). This has now climbed towards cycle extremes, suggesting there is growing scope for significant reversals.

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