Market reaction was fairly subdued following the weekend’s historic referendum that rejected the Troika’s offer. The ball is now in Greece’s court as the government must provide a new proposal. The key question is whether creditors are willing to offer meaningful debt relief.
The Greek government is willing to accept more austerity, but only in exchange for debt relief in some form. The problem is that Greece’s creditors can’t offer more than a token reduction in debt because of the moral hazard problem; other countries in the currency union may then also demand “a better deal”. On Greece’s side, the country can get maximum debt relief via default, giving it a strong incentive to hold out.
Our geopolitical strategists still estimate the probability of Grexit to be 20-30%. If Greece heads down the exit path, we believe that global markets will likely see the country as an outlier in the near term. Contagion to U.S. financial markets will likely be minor, unless the euro breaks down and sends the U.S. dollar sharply higher.
As for Peripheral sovereigns, the risk/reward balance is not very attractive at these levels. Our global bond service remains underweight the sector versus core European bond markets. Spreads have widened by about 50 basis points over the past couple of months, but they still do not offer value good enough to justify gambling that the Greek situation will come to a speedy and smooth conclusion. The government’s use of IOUs to pay its bills domestically would signal that the situation could hang over investors for another long while.
We would be tempted to buy Portuguese, Italian and Spanish bond spreads if they were to widen another 50 basis points, or if the Troika signals that it is willing to provide meaningful debt relief.
Nonetheless, we would view any purchase of Peripheral debt as a tactical trade rather than a strategic buy-and-hold. BCA’s Global Investment Strategy service argues that investors could begin to question the view that Greece is an outlier when Eurozone economic growth slows, debt/GDP ratios start to rise again and voters in the Periphery refuse more fiscal austerity. The saga continues.