Greek Fire Part IV

I have written on several occasions (see for example Germany exports its disease Sep 3, No Easy way out for Eurozone Peripherals Oct 30) about the problems facing especially Greece, Spain, Portugal and Ireland and suggested to shy away from respective government bonds (although last time I upgraded the market view with respect to Irish government bonds). I also stated that I dont believe that Greece can enact the necessary heavy dosage of fiscal tightening and structural reforms on its own. On the one side, the extent of the mess is enormous given the size of the fical deficit/debt, the magnitude of the economic imbalances and the low competitiveness. On the other side, the public acceptance for restraint as well as the political power to enact any meaningful change is clearly limited in a country plagued by faulty statstics, a very high level of corruption, a super-sized black economy as well as a generally low inclination to pay taxes.
In turn, Greece needs outside help in the form of carrots (i.e. money) and sticks (to enact structural reforms) and I am convinced that in one way or the other, they will get it even if it wont be called a bail-out (in order to satisfy the Maastricht/Lisbon treaties). While it is difficult to make predictions about what form the support will take and what the timing of any such move will be, the latest press reports have given some clues about the sticks: As this Reuters article states, the European Commission will suggest to Greece to cut nominal wages in the public sector and set a ceiling for high pensions amongst others.
This would amount to little else than what the IMF would demand as well. More importantly, if the EU/Eurozone or a sub-group of EU countries were to lend money to the Greek and do get real structural change in return, it would not necessarily need to be a bad thing for either side. Furthermore, if the conditions for getting any bail-out money are hard enough, then it should not worsen the moral-hazard problematic as the Spanish/Portuguese/Irish/Italian etc. would have strong incentives to take care of their domestic problems on their own before they are faced with a buyer's strike and need to revert to a bail-out as well. Interestingly, Portugal and Spain which always have been in denial over their structural as well as fiscal problems, seem to at least start acknowledging the need for more significant budget cuts.
Overall, I am still convinced that the Eurozone faces a multi-year period of low nominal GDP growth (amid little real growth and only limited inflation). As the pressure to enact significant fiscal tightening measures is growing and as a potential Greek bail-out seems to have strings attached, the probability of such a low-growth outcome remains high.

With respect to market pricing, peripheral spreads have ballooned drastically since the start of the year and my suggestion to underweight Greece, Portugal and Spain has been proven correct. Also the relative assessment of Italy has proven right as Spain is finally trading with a pick-up relative to Italy in the 10y area. But where to go from here? As spreads have been widening, the carry available has been improving. Furthermore, given that Bund yields remain at historically low levels, carry remains an important driver of total returns.

Intra-Eurozone spreads: unprecedented volatility vs. significant carry

Source: Bloomberg

Earlier this year, I suggested to upgrade Ireland back to neutral while remaining underweight on Spain, Portugal and Greece. Structurally, not much changed and the fundamental risk associated with these countries has not diminised materially (but in my view it has also not risen). On the other side, especially the level of Greek spreads is discounting a significant amount of problems down the road. In turn, the risk-reward for investments into peripheral government bonds has improved. I maintain my negative fundamental/structural assessment of these countries but given the current spread levels, I temporarily upgrade the market view back to neutral on a tactical basis.