Exit from the Euro would be very painful for Greece. Cut off from the ECB’s
liquidity facilities, the Greek banking system would face collapse. And, as
foreign lenders cut their credit lines to Greece and depositors struggled to
extract their deposits ahead of the banks’ failure, the Greek financial system –
and with it the Greek economy – would seize up. Given the costs of exit for both
Greece and other Euro area countries, a powerful incentive exists for the two
parties to reach a compromise that permits continued Greek membership of the
Euro area but in the meantime the pan-European game of chicken continues
and with each iteration of this game, the political cost to the two parties
involved has increased. Goldman sees three key
scenarios from this: Muddle Through (this
is their 'Goldilocks' base case and implies continued Greek EMU membership, and
ECB funding for Greek banks, but also continued pressure on Greece to
reluctantly implement reforms while at the same time the remaining Eurozone
countries very gradually deepen their policy integration) - which is modestly
positive (though likely more range-bound) for equities and bonds with weak
growth and Fed QE3 potentially pushing EURUSD up to 1.40; a Fast Exit (the least likely and most
bearish scenario with Greece walking away unilaterally potentially
knocking 2 percentage points of Euro-area GDP - even assuming substantial
central bank counter-measures - and if the firewall were ineffective, a
Euro-unraveling and an associated double-digit fall in Euro-area GDP); and
a Slow Exit (Greece
excluded once firewalls are in place - with pan-European deposit
guarantees now front-and-center as opposed to simple banking bailouts to avoid
the now-critical bank-run's contagion - which constitutes modest GDP impacts and
compression in risk premia - and appears to what the market is
discounting as likely).
A Slow Exit with a modest 1% hit to Euro-area GDP appears to be priced in
And the impact on the SXXP (Stoxx 600 broad European equity index)...
Current SXXP pricing appears to be pricing for a 1% drop in Euro-GDP.
A fall back down to the 2009 low of 159 in the SXXP would be consistent with GDP contracting by around 5% to 5.5%. A fall back to the pre-LTRO low at the end of last year, 215 on the SXXP, would be consistent with the market pricing Euro area growth of around -2.5%.
The Scenarios
In summary and in the worst case, further substantial EUR weakness is possible, including against the Dollar in scenarios where Greek exit cannot be ring fenced effectively. This could be due to a lack of time (Scenario #2) or simply because the European institutions fail to prepare well enough (Scenario #3). In most other scenarios a gradual rebound of the trade weighted EUR is likely after some temporary decline. With regards to EUR/$ specifically, we continue to think that the US balance of payment situation exerts gradual downside pressure on the USD, and hence contributes to the stabilisation of EUR/$. Any sign of a non-disruptive solution, in particular as part of Scenario #3, could lead to a rapidly declining risk premium and hence EUR strength. In that case even our 12-month 1.40 forecast in EUR/$ may be too timid. But this is not our base case. In the base case we expect range-bound behaviour of the Euro in the near-term.
Simply put CB counter-measures are assumed to save any dramatic downside unless Greece surprises unilaterally.
A Slow Exit with a modest 1% hit to Euro-area GDP appears to be priced in
And the impact on the SXXP (Stoxx 600 broad European equity index)...
Current SXXP pricing appears to be pricing for a 1% drop in Euro-GDP.
A fall back down to the 2009 low of 159 in the SXXP would be consistent with GDP contracting by around 5% to 5.5%. A fall back to the pre-LTRO low at the end of last year, 215 on the SXXP, would be consistent with the market pricing Euro area growth of around -2.5%.
The Scenarios
The market impact of the three ScenariosScenario #1: Muddling through
In the most likely scenario, the new Greek government emerging from the June 17 election neither chooses to exit the euro nor agrees unconditionally to implement the existing EU/IMF programme. This will lead to a cessation of troika payments, but would not of itself constitute Greek exclusion from the Euro area, provided Greek banks continue to enjoy access to ECB facilities. Such a scenario is consistent with our forecast for European macro variables and asset prices.
At the same time, there will also be (slow) progress toward deeper policy integration (financial market and banking regulations, fiscal coordination, and ex ante risk-sharing), in order to build the firewall necessary to make the Euro area resilient to a possible future Greek exit. In this scenario, the very large insurance premium priced into US Treasuries and German Bunds should gradually dissipate. Equities would likely rise, but initially only modestly given the continued weak growth picture.
Scenario #2: Fast exit; Greece walks away
Were Greece to unilaterally exit and introduce its own currency, the ECB would presumably halt the flow of Euro liquidity to Greece. Greece would be cut off from capital markets, forcing the government to a primary cash balance. The knock-on dislocations to the real economy could lower Euro area GDP by up to 2 percentage points, even assuming that robust counter measures are taken by the policy authorities. Our expectation would be that the policy response would be substantial. The hit to earnings expectations would likely push the SXXP down to 225, although uncertainty could push the ERP even higher (from 8.7% currently), pushing the SXXP back to at least the 215 low of last September or more and 10-yr rates to as low as 1.5% and 1.0% in the US and Germany respectively.
Scenario #3: Slow exit; Greece is excluded
There is no legal mechanism to force Greece out, but in practice it would be possible de facto by denying Greek banks access to ECB facilities. We see this as less likely than #1 but more likely than #2; it is more market friendly than #2 being a more “managed” exercise. Most likely, peripheral countries’ would have received assurance that the ECB will intervene in bond markets to limit contagion preventing a sharp widening in spreads. The likely hit to GDP of up to 1% is already discounted in equities although uncertainty may result in an initial overshoot. If the policy response was powerful, we could see a strong rally from any lower levels.
Upside and Downside Risks Relative to the Base CaseScenario #1: Muddling through
In this scenario, we are likely to see market stabilisation over time as current fears over systemic risks fade to some degree as investors see gradual continuous progress in the area of deeper policy integration (in the areas of financial market regulations, fiscal coordination, and eventually some form of ex ante risk-sharing) among all countries currently adopting the euro, in order to build the firewall necessary to make the Euro area resilient to a possible future Greek exit.
Rates
In such baseline state-of-the-world, the very large insurance premium priced into German Bunds and US Treasuries since the Greek PSI last summer should gradually dissipate as Europe becomes slowly more integrated and resilient to events in Greece, allowing yields to re-align to their macro underpinnings. This process will likely happen at a quite slow pace and will be largely influenced by the visibility on the medium-term framework for Euro area (especially in the areas of banking and fiscal integration). Based on our current baseline macroeconomic forecasts for the main advanced economies, 10-yr government bond yields should trade above 2.00% in both the US and Germany, with ‘fair value’ rising to around 2.5% on a 2013 horizon. At the current juncture, swings in the sovereign risk premium easily overwhelm changes in macro expectations. For example, should a scheme like the Debt Redemption Fund receive political backing, bond markets would quickly react to this prospect even if the implementation phase would be at some future date.
Within this cornice, we expect peripheral spread curves to remain relatively steep, underpinned by the ECB’s ‘term liquidity on demand’ policy. Both intra-Emu spread levels and slope would interact primarily with shifts in the growth outlook, which interacts with fiscal variables. An exercise of mapping spreads to fundamentals predicated on the baseline scenario would see 10-yr differentials with Germany head towards 250 bp-300 bp for Italy (currently 425 bp) and 300 bp-350 bp for Spain (currently 475 bp).
Over time, possible more positive developments might take place. We have for example discussed the merits of the Debt Redemption Fund, which has recently been endorsed also by the European Parliament. Any hint of the Euro area moving in these directions would result in a sharper rise in German yields towards their macro equilibrium, and a compression of German swap spreads to 20 bp-25 bp (from 50 bp currently), with 10-yr Italy trading around 150 bp-200 bp over mid-swaps.
Equities
The equity market would likely benefit from some modest compression of the ERP from the recent rises that emerged post the Greek election. However, even as we see more gradual progress, the upside would be limited in the near term by the stagnation of profit growth this year (we forecast -1% EPS growth for 2012 and 12% for 2013). We would expect a relatively flat return over 3 months. To reflect this, and recent market moves, we revise our 3 month target down to 245 for SXXP (from 260) and 2150 for Eurostoxx 50 (from 2350). We continue to forecast a rise to 290 over 12 months and 2800 for the Eurostoxx 50. We would continue to expect the core to outperform the periphery, DAX to outperform CAC, global stocks to outperform domestic (GSSTBRIC/GSSTDOME) and stable growers to outperform (GSSTGRTH).
Translating this into FX markets, we would have to look at the following factors. The correlation of the trade weighted Euro with risk aversion would suggest that range-bound price action in other asset prices will translate into a similar pattern in the Euro. Ultimately the decline in risk premia should lead to a rebound of the Euro, consistent with a reduction of currently stretched short positions. We also assume a quite notable rebound in European equity indices on a 12-month horizon. In terms of timing of the moves, it is important to highlight that a rise in German bond yields, a rise in European stocks and the Euro would all more or less coincide, and depend on the broader fiscal risk premium. In such a scenario, we could see the Euro rebound against the currencies of key trading partners like Sterling or the USD.
However, it is important to not overlook factors affecting other currencies, as mentioned above. Over the medium term, the USD in particular will likely remain under downside pressure reflecting the US economy’s poor external imbalances. We also still think that QE3 by the Fed remains a likely scenario. The combination of these USD negative factors with a back-loaded decline in the Eurozone fiscal risk premium is consistent with our current forecasts of a flattish EUR/$ trajectory for up to six months and additional appreciation towards 1.40 in 12 months.
Scenario #2: Fast exit: Greece walks away
The likely impact of a chaotic and unilateral exit of Greece from the euro would be very negative for confidence in the short term and would undoubtedly push the ERP higher. Of course, much would depend on the details and speed of any policy steps put in place. Assuming robust policy responses, we would estimate an initial hit to the Euro area’s GDP of up to 2%. However, if a Greek exit was followed by no convincing policy responses, and it precipitated a broader collapse of the Euro area, then the outcome would be very much worse with a fall in GDP that could approach double digits.
Rates
With the demand more vulnerable after a deep fiscal retrenchment, a more aggressive injection of liquidity by the major central banks would be likely if peripheral sovereign spreads in Europe were to increase as they did last November. Arguably, AAA-rated government bonds are discounting such catastrophic outcome to a greater extent than other asset classes, such as non-financial stocks and corporate credit. Nonetheless, gains on government securities would be positive should these events materialise, with 10-yr rates tentatively falling to 1.5% and 1.0% in the US and Germany, respectively. A temporary overshoot of these levels is likely. Sovereign spreads, particularly at the front-end of yield curves, could become a more explicit policy target.
Equities
Assuming some policy response limiting the contraction in Euro zone growth to less than 2%, we would expect the market to fall back to around 225 on the SXXP . However, the initial uncertainty may push the ERP higher in the short run, overshooting the pure economic and earnings impact, with a possible decline back to the 215 low reached in September of 2011.
In the absence of meaningful policy response equity prices would respond very negatively. While market action so far suggests that equities that are most directly at risk may have already priced in a more serious outcome than the broader market (Greek stocks, periphery equities and banks in particular), it is difficult to draw too much comfort from this. The sheer chaos of a euro unwind and the uncertainties over pricing contracts, and the extent of the counterparty impacts would not be obvious for some time; investors would probably assume the worst and ask questions later. Under the worst case, with a full-blown bank run in Greece triggering widespread disruptions elsewhere, we could envisage a fall in the SXXP possibly to the 2009 low of 158.
And FX
In such a scenario, risk aversion would rise across the board and other regions may not be shielded from contagion. Quite mechanically, this scenario would lead to broad trade weighted EUR weakness, as well as broad USD strength. At the nexus of these two trends, EUR/$ would likely drop substantially – almost certainly marking new lows well below the 2010 trough of 1.19. In such a scenario it would be quite likely that a number of short-selling bans would be imposed on European assets and hence the Euro would become a natural “safety valve” for investors trying to find ways to protect their Eurozone assets against further declines.
Should the counter-measures prove insufficient and the Euro area disintegrates, we would see a substantial relative move of the re-introduced legacy currencies. The currencies of the fiscally strong countries like Germany, the Netherlands or Finland could re-appreciate substantially, possibly reaching new highs relative to non-European currencies. At the same time, peripheral currencies would likely depreciate vis-à-vis most non-Eurozone currencies, and – of course – relative to the currencies of the strongest current Eurozone members. This extreme scenario would likely be accompanied by some overshooting, hence it is very difficult to make any predictions.
Scenario #3: Slow exit: Greece is excluded once firewalls have been built
As mentioned above, the outcome here is relatively similar to scenario 2, but is seen as more positive by the market as it is a proactive choice by the Euro zone following a buildup of firewalls, rather than a unilateral decision by Greece. The firewalls would reduce the economic hit of a Greek exit to no more than 1% in our view. The negative aspect of this scenario is that it raises the fear in bond markets that other countries are at risk of being forced out. However, if the decision is made to force Greece out, it is likely to be taken by all other Euro area members and would presumably be taken with confidence that more policy support to stop contagion would be in place.
Rates
Fear of contagion could push spreads of peripheral countries even higher than what we have seen last November. On the other hand, given that this is a more “managed” exercise implemented when the necessary firewall measures are in place, it is likely that peripheral Euro area countries’ would have received the assurance that the European Central Bank will intervene in the bonds’ markets (if necessary) to avoid or limit contagion either directly or by offering unlimited liquidity to the banking sector. This should result in a relatively more positive environment for bonds’ markets than the one described in the Greece walks away scenario. In this case, we see spreads of peripheral countries widening by less as the intervention by policy-makers is likely to be more forceful and happen in a more timely fashion.
Equities
This scenario would be less negative than scenario 2. The up to 1% hit to GDP is already what we think the market is discounting for this year, so any further falls would be triggered by a rise in the ERP from the already very elevated levels (currently we estimate at around 8.7%). Indeed, any initial falls could reverse pretty quickly. Above all, markets dislike uncertainty, and the clarity of a decisive move by the Euro zone on Greece could bolster confidence. If convincing firewalls and other policy supports were put in place the market could rally strongly from a lower level, as we saw following the LTRO.
FX
In this case the risks for a temporary overshooting – would be reduced. The new Greek currency would sell-off sharply. The trade weighted EUR would also weaken, but after some temporary overshooting (less than in Scenario #2) the Euro could then rebound, depending on the success of the ring-fencing.
It is possible that this scenario would not even push EUR/$ to new cycle lows below 1.19. This is due to several factors. First, the degree of preparation may keep contagion to a minimum. Second, given this scenario would materialise only in the more distant future, Dollar downside forces would also have intensified and hence would partially neutralise the pressures on the Euro. Third, the fact that Greece-related frictions are finally removed, could lead to more efficient political decision making in the remaining Eurozone countries. Finally, given current positioning in FX markets, we think that this scenario is largely priced already, which further limits the likelihood of a persistent move lower – as long as the ring fencing ultimately proves successful.
In summary and in the worst case, further substantial EUR weakness is possible, including against the Dollar in scenarios where Greek exit cannot be ring fenced effectively. This could be due to a lack of time (Scenario #2) or simply because the European institutions fail to prepare well enough (Scenario #3). In most other scenarios a gradual rebound of the trade weighted EUR is likely after some temporary decline. With regards to EUR/$ specifically, we continue to think that the US balance of payment situation exerts gradual downside pressure on the USD, and hence contributes to the stabilisation of EUR/$. Any sign of a non-disruptive solution, in particular as part of Scenario #3, could lead to a rapidly declining risk premium and hence EUR strength. In that case even our 12-month 1.40 forecast in EUR/$ may be too timid. But this is not our base case. In the base case we expect range-bound behaviour of the Euro in the near-term.
Simply put CB counter-measures are assumed to save any dramatic downside unless Greece surprises unilaterally.
No comments:
Post a Comment