UAE. The world has become obsessed with Greece, or Grexit as the country’s potential departure from European Monetary Union has become known. G8 leaders met at the weekend and promised to support the eurozone’s most indebted country, but that promise has been made before and with little credibility.
The real fear is that Spain becomes a victim and thus this coming weekend’s meeting of European Union leaders takes importance in the mind of the world’s investment community.
In truth though, little ever comes from summits and the real test of European resolve will come not this weekend, but on 17th June when Greece’s electorate expresses its democratic preference for what is in effect the status quo or departure.
Until then, it is unlikely that much will happen to make any real difference to Greece’s long march towards the exit door. The issue for investors is that what happens afterwards is a huge unknown.
The cost of a Greek exit from the Eurozone was recently put at US$1 trillionn by the Washington-based Institute of International Finance (IIF). To put this in context, US$1 trillion is approximately all the resources the European countries have at their disposal to deal with debt and banking sector problems throughout the Eurozone.
From a tactical perspective it is quite reasonable to believe that an exit will prove to be the catalyst that shunts the ECB in the direction of engaging in quantitative easing. That policy response, if overwhelming, could well prove to be a buying opportunity.
Certainly from a positioning perspective, the FX market is now so short euros that a rebound is very probable between now and the elections on 17th June. Net short positions in the EURUSD market are at all-time highs. It is difficult for EUR to move much lower unless the ECB slashes rates unexpectedly.
Even then, a plunge in EUR is unlikely until there are fewer participants in the FX market looking to sell euros. Hence the resilience of the world’s second largest reserve currency in the face of a huge fiscal unknown in southern Europe.
Our house view remains that EURUSD 1.15 is very probable over a longer horizon. The route to that point will not be a straight line, meaning that our clients must have a balanced risk exposure in portfolios.
In terms of our tactical view therefore, we recommend caution with a bias towards hard currency bonds, but with an eye for long-term buying opportunities in Emerging Market hard currency bonds and equities.
Despite the substantial sell-offs in Emerging Markets equities since Greece’s last elections we continue to have a very positive outlook for Chinese equities. In recent days, the Chinese leadership has re-affirmed its commitment to slowly lowering property prices to reduce 1) the cost of housing to middle income families and 2) to reduce the possibly systemic risk to local government balance sheets. At the same time out-going Premier Wen Jiabao at the weekend made a clear commitment to stimulating growth.
Recent cuts in the banking sector’s reserve requirement have been accompanied by falls in the cost of corporate borrowing and in the interbank market. Command economies – where lending for decades has mostly been by diktat – don’t regulate the price of capital. Rather, it’s the quantity of lending that is key.
On this point, last month’s lending data came in below expected levels by almost 10%. Regardless of why, it is clear that this brings us closer to the point at which the PBOC starts to embark on more systematic reductions to the reserve requirement. A-shares are protected from international capital and FX gyrations in the way that H-shares listed in the open capital markets of Hong Kong are not.
Elsewhere, the big move down in cotton prices will eventually provide for lower non-food inflation rates, particularly if accompanied by additional declines in energy prices. Traded cotton prices rose almost 70% between mid-2010 and Q1 2011 adding to upward pressure on non-food consumer prices throughout the emerging world.
The current active cotton contract has fallen 15% since the end of April with further declines likely as the commodity market begins to downgrade its expectations for global growth and demand. Clothing manufacturers and consumers of cotton-based retail products should soon start to see and benefit from more competitive prices.
One potential beneficiary from slower growth and non-food input prices is India, although the inability of Delhi to get its fiscal house in order means that we are reluctant to take that bet for now.
Currency and capital flow risk dominate in India and are likely to do so for some time. The Sensex has been one of EM’s most expensive equity markets throughout the last year and it therefore is vulnerable to further sell offs by foreign institutional investors who are experiencing added currency volatility.
Foreigners remain net sellers in both the equity and bond markets, with local participants the buyers. Until we get a signal that FII money is comfortable with FX risk and fiscal oversight, we continue to prefer Russian and Chinese exposure to Indian.