13th July 2015
The deal agreed between eurozone leaders in Brussels this morning provides a basis for a third bailout package for Greece and for Greece to stay in the eurozone writes Christophe Donay, chief strategist at Pictet Wealth Management…
An eventual new bailout agreement will have to be voted through by 10 national parliaments, including that of Greece. However, European leaders will have negotiated on the basis of what will be politically acceptable at home, so the risk of a veto looks limited.
For Greece, the €86bn package will allow it to meet its financial commitments for the next three years. But the conditions are extremely tough, including spending cuts, tax rises, pension reform, and the creation of a trust fund for privatisation receipts. The Greek economy faces a painful slowdown in the short term. The most immediate concern will be to avoid a banking collapse—the ECB will likely help by maintaining Emergency Liquidity Assistance (ELA) at €89bn.
The agreement on Greece has not resolved the eurozone’s fundamental problems. The roots of the Greek crisis are to be found in our concept of the Great Divergence—the diverging trajectories of public-sector debt and economic growth. Greece has been overwhelmed by the Great Divergence, but many euro-zone countries, including Italy and periphery countries, are also struggling with it.
Moreover, the Greek crisis has shown that there are two camps in the eurozone: the ‘rigorists’, led by Germany, and the ‘solidarists’, led by France. The Franco-German motor that has traditionally driven the European project is therefore at odds on this key issue. This schizophrenia in the eurozone will continue to create tensions over fiscal and crisis management.
It remains an open question whether the eurozone can fix its structural challenges. Over the long term, we attach a 45% probability to the eurozone resolving its problems through ‘deepening’: the creation of a fiscal union. There is only a 10% chance of the eurozone muddling through in its current form, and this scenario would depend on the ECB monetizing eurozone sovereign debt. We see a 45% possibility of the eurozone eventually breaking up under the impact of mounting sovereign debt, weak economic growth and a lack of political unity.
Concerns about Grexit will now dissipate, and the other big worry for the markets in recent weeks—the stockmarket crash in China—is also lifting. Measures by the Chinese authorities are helping to stabilise the market, and although the sell-off may well resume, contagion to the Chinese economy and to global equity markets should be limited. Implied volatility in European equity markets had moved into crisis territory in the past few weeks, but will now normalise.
Markets will switch their focus back to fundamentals. These remain supportive. We continue to expect US growth to pick up in Q2 and for the rest of 2015, and an improving credit cycle bodes well for stronger economic expansion in the eurozone. We forecast real GDP growth of 2.3% in the US and 1.3% in the eurozone in 2015. With China set to achieve a managed slowdown to growth of around 6.5% this year, the global economy looks resilient.
This favours DM equities, which have been the best-performing asset class so far this year and will remain so. DM equities will benefit from improving earnings growth (which we expect to reach double-digits for both the US and Europe in 2016) and further valuations expansion.
Long-term interest rates will gradually rise as the global economy strengthens. We expect 10y Bunds to trade up to 1.25% and US 10y Treasuries to 2.7% in Q3. However, US Treasuries will retain their role as a protection asset, given their negative correlation with equities.
The euro has jumped slightly on news of a deal on Greece, but as attention moves back to fundamentals, stronger US economic performance and anticipations of rising US interest rates mean a weaker EUR/USD. We are still only mid-way through a bull-run in the US dollar, which historically lasts around 4 years on average.