Greece Votes No In Referendum on Creditor Plan

On July 2 I wrote that I expected Greece to vote Yes in the referendum. I expected the Greeks to vote in favour of anything that would restart the ATMs and get cash flowing through the banking system once again. As it turns, the Greeks voted no. Why did I and many professional investors expect a Yes vote? Because we have substantial savings. I made a forecast apparently empathizing with the average Greek but without a good understanding of the average Greek and an understanding of their circumstances.

5 years of austerity had not yielded more jobs. The probability of getting a job was low. There was little in the bank to protect or release anyway. And the Eurozone finance ministers had been making a concerted case basically threatening the Greeks into voting Yes.

This last factor could cynically be interpreted as an intentional strategy to jettison the Greeks from the currency union if one were inclined to conspiracy theories. Perhaps the Eurozone was trying to correct an earlier error, that of bending the rules to admit the Greeks in the first place. Perhaps they had just tired of negotiating with a deadbeat who was seeking aid on its own terms. Perhaps the Eurozone had tired of subsidizing Greece (the details are beyond this discussion but yes, there were net transfers to Greece), and unable to eject Greece under the current rhetoric of unity at all costs, needed to force Tsipras to the edge, and then force the Greeks to voluntarily eject themselves. If this is true, then job done. You should see an aid package (the Eurozone will not abandon an erstwhile member) involving debt forgiveness, which is what Greece had sought in the first place, but which the Eurozone could not give and then retain Greece in the union. As important as keeping its members firmly in the union is ensuring that members pay their dues and respect the bye laws.

With a No vote Tsipras can negotiate more aggressively but whether the creditors will be accommodating is another matter. If the conspiracy theory is correct then he has given Merkel her wish and maybe the negotiations will be less confrontational. This is unlikely. The tensions if anything may intensify. A lot depends on Tsipras approach. He may cock a snook at the creditors and refuse to pay, Greece is after all already in default. There is not a lot that the Eurozone can do, short of gunboat diplomacy, something that is unfashionable these days and especially with the Eurozone. A martial solution is something the West has long lost its stomach for, and a German led coalition would never make it past the broadsheets and blogs.

The creditors may recognize that even in the face of an acquiescent Greece that never went to the polls, or a Yes vote, they were never going to get the full face value of their debt back, and that they have now got the Greeks off their backs, some reasonable write down of the debt is acceptable. A more sinister scenario exists. It may have been necessary to induce the Greeks to eject themselves from the union to encourage responsible behaviour among existing Eurozone members but it may now also be necessary to deter further exits by demonstrating the high price of leaving the union.

As I have said before, Greece has always had a choice between austerity in Drachmas or austerity in Euros.

Greece Referendum. Analysis and Investment Opportunities.

Greece will conduct a referendum on July 5 regarding a creditor plan of reorganization. The referendum is framed as a Yes/No vote to either accept or reject the creditors’ proposals.

1. The vote as it is framed is strictly about accepting or rejecting the creditor proposal. However, the consequences of either a Yes or a No go beyond the creditor proposal, they go to whether Greece intends to be a part of Europe, or not.

2. There are a number of scenarios:

a) Yes. Tsipras government resigns. A new government will have to be formed which is happy to comply with the referendums implications. Financial and liquidity support will resume and details of a bailout will be finalized and implemented.

b) Yes. Tsipras government does not resign. Syriza has campaigned for anti-austerity and recommend the people vote No so a Yes vote would destabilize the government. It is unclear how the creditors will proceed in negotiations with Syriza. Syriza would have to honour the implications of the Yes vote and negotiate accordingly. The ECB may not be as quick to lift the suspension of ELA and negotiations would have to continue to finalize details. These negotiations could be problematic if represented by Syriza.

c) No. Tsipras government will have a strengthened mandate. The ECB would certainly ringfence the Greek financial system and maintain suspension of the ELA. Greece may be explicitly removed from TARGET2 which would isolate its financial system. There are many possibilities under a No vote since it would imply chaos and a likely exit of Greece from the currency union and perhaps from the European Union as well.

3. Short term effects: Equity markets will likely react well to a) above. The uncertainty of b) above means that any upside is likely to be fragile. Volatility could persist until a clear deal could be reached. In c) above the immediate impact will likely be a sharp sell-off as investors seek to de-risk and avoid any potential Black Swan events. “We know how bad it is and it ain’t so bad, but we don’t know what else we could have missed…” would be the likely thinking. European markets are still on average about 10% in the money year to date and investors will want to protect that.

4. European equities will correlate closely with BTP and BONOS spreads versus Bunds in each of the above scenarios. For 30 year BTPs, spreads could tighten below 100 under a) or languish in a 100 – 150 range under b). Under scenario c) the immediate impact could be big. Spreads were over 400 in 2011 but with the ECB’s OMT, QE and LTRO operations a widening to 200 would be extraordinary and would be a trigger to buy the spread. A similar analysis applies to 30 year Spanish spreads.

5. Longer term positioning.

a) Scenario a) provides Greece a lifeline. Depending on the final nature of the bailout the outcome could be long term negative for Europe, if for example, the creditor plan was unrealistic, draconian and would cause Greece to require another bailout in a few years’ time. A realistic deal would see some form of debt write-down with conditions to rehabilitate the Greek economy. Such a scenario would be long term positive.

b) Scenario b) could not realistically play out over the long term since the raison d’étre of Syriza was anti-austerity.

c) Scenario c) presents the most interesting long term investment opportunities.

I) The Greeks might soften their demands but the probability of this after a No vote is small. The probability that the Eurozone would soften their demands following a no vote is similarly remote given the contagion risk of moral hazard to Spain, Italy, Portugal.

II) Greece is already de facto in default and a No vote would formalize this. Negotiations would begin, or in this case, resume, with creditors. In this case, creditors would be quite powerless to negotiate for anything except to eject Greece from the union and suspend all aid. Keeping Greece in the greater union but not the Euro would provide a template for subsequent member exits and is therefore unlikely to be supported by Germany or France.

III) Greece would have to mint its own currency, which would probably depreciate some 40%-50% instantaneously. Some form of capital controls will be needed to ensure the success of the new currency.

IV) At this point but not before, Greek assets and legacy debt might present value.

Greece. Yes No. What Then? Tsipras and Merkel At Last Agree.
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I was undecided before but the rhetoric from Berlin has now convinced me that for once, Merkel and Tsipras agree. They both want the Greek people to vote No in the July 5 referendum on creditors’ terms.

Greece has been on explicit financial aid since the first bailout in 2010. In 2015, since Syriza won the general elections, all Greece has been trying to do is renegotiate the terms of its aid. It is not a bailout or a refinancing or debt reorganization, its aid. For the Eurozone, its members already struggling fiscally, with the exception of Germany, aid to an unproductive member was never sustainable. That the Greeks did not have a commercially acceptable business plan exacerbated the situation. Reprieve (for the EZ) came in the form of Syriza. Under ND, austerity had failed but its effects would only manifest will past the elections. Had Greece failed under a compliant New Democracy the effectiveness of the Eurozone’s austerity programs would have come into question. Rather fortuitously, ND lost to a strident Syriza intent on tearing up the status quo became a convenient pawn in a gambit designed to see Greece out of the Euro, by its own hand, and facing painful consequences – as a warning to Portugal, Spain and Italy, that exit has a price too high.

Unfortunately, for the Eurozone and Syriza, the vote will likely be Yes. Quite what happens after such a vote is another matter but, polls notwithstanding, the human tendency is to go with the devil you know. A Yes is more probable because, Greeks do want to stay in the Euro, they receive aid from the Eurozone, their borrowing costs are or were held down by the Euro, but most of all, they cannot envisage life without the Euro, or life with a Drachma. More immediately, the banks are closed and pension disbursements are drying up. Greece and her banks are short of cash. In the short term only Emergency Liquidity Assistance can restore the flow of cash and the ECB will certainly not raise the ceiling on ELA if there is a No vote. By imposing capital controls and a bank holiday, Tsipras may be encouraging his people to vote Yes just to free up the flow of money.

A Yes vote will mean a loss of mandate for Tsipras and his Syriza since he has recommended to his people to vote No. Tsipras may have to resign, triggering fresh elections. If so, a new government will need to be formed during which time it is not clear what the position of the Eurozone will be, they will have no one to negotiate with. The position of the ECB will be similarly unclear. Should they provide relief and lift the ceiling on the ELA? If they did, cash would start flowing again while Greek default risk would still be ring-fenced within the Greek financial system. So it is likely they would. Tsipras may not resign. A cynic might expect him to hold on to his position and resume negotiations with the creditors. He has already shown sufficient flexibility in between the time he called for the referendum and when the referendum would be held by attempting to negotiate terms with a softer stance. In any case, a Tsipras government or another government would have to respect the result of the referendum in negotiations with the creditors, basically accepting the terms of the initial creditor plan. The latitude for any government to be obstructive is significantly limited by a Yes vote. Very likely a deal will be struck and bailout disbursements would follow. Given the draconian terms of the creditor plan, Greece would limp along until the next crisis.

A No vote would keep Syriza in place but could well put Greece out of place. While it appears that anything is possible, if we are to believe the myriad official voices from Brussels to Berlin to Athens, Greece would probably be forced out of the Euro. Theoretically it could default and remain within the union, since membership does not explicitly preclude default, but the going concern status of Greece would be in question and there might be sanctions regarding Greece’s access to the European TARGET2 payments system. Another possibility might be Greece being removed from the currency union but not the European union in a similar way that the United Kingdom is part of the EU but has its own currency. In any case, Greece has for all intents and purposes already defaulted on the IMF loan due June 30. The IMF would simply formalize this by changing its status from being in arrears to being in default.

Under a No vote and default, could Greece remain in the Euro? Theoretically it could. Greek debt in Euro would default and face writedowns in the usual fashion that defaulted dollar debt faces writedowns. A plan of reorganization could still be formulated with Greece within the Euro that would restructure its debt. Creditors would still impose conditions, and Greece would negotiate for leniency, in fact the negotiations might look very much like what we have experienced in the past 5 months. The negotiations thus far have not only been ineffective, they have been irrelevant. Now it may be that the Eurozone then decides to remove Greece from the currency union. It may keep Greece in the broader union, or it may also eject it altogether. That is a separate analysis which would involve longer term strategic considerations as well as historical, cultural and emotional factors. The logistics of default are another matter. Upon default, Greece would have to be prevented from creating further liabilities, which it can do within TARGET2. Shutting Greece out of TARGET2 or limiting its access to it would be the equivalent of Europe unilaterally and exogenously imposing capital controls on Greece, which surely would encourag
e Greece to leave the Euro.

What other alternatives does Greece have? Tsipras has evidently approached Russia. Russia, however, is not entirely in shape for such extravagance. While the Russian economy has stabilized somewhat rates remain elevated and the currency may yet begin to weaken again and the budget has already begun to deteriorate again. Putin might be happy to spend some money on entertainment and Greece would be a source of worry in NATO’s backyard but so far Tsipras’ overtures don’t seem to have borne fruit. Unless they are waiting for a more opportune time to come out.

The polls have been all over the place beginning with favor for a Yes, to a more even balance to favoring a No. Polls tell you what people wish they could do, not what they will do. And even when the votes are counted, a new uncertainty will have begun.

China Equities. Fundamentals Positive. Valuations High In Places. IPO Activity Sapping the Market.
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Long term positive China on reform and liquidity.

Medium term volatility from valuations and IPO issuance.

There are reasons to be optimistic about the Chinese economy in the long run due to structural reform. Current growth rates will slow but China is reorganizing itself to a more durable model.

Political reform, notably the leaning away from rule of Party to rule of Law. The renewed importance of the Chinese constitution.

Economic reform. Refinancing the local governments, lowering debt service costs. Rebalancing leverage away from over leveraged local governments and corporates towards households and central government.

Financial market reform. The introduction of market discipline such as fewer bailouts and thus more use of the bankruptcy code.

The PBOC is in the midst of expansionary policy.

QE lite via LTROs with muni bonds as HQLA collateral.

Cutting interest rates

Cutting RRR.

General deregulation of the banking and savings industry.

This will favor the banks.

The stock market has been very volatile.

Valuations in parts of the market have overshot fundamentals.

The market has simply run up too high.

IPOs are sapping fund flows.

Not all parts of the market are overvalued.

HSCEI is trading on 9.4X 2015 est earnings.

SHCOMP is trading on 17.5X

Shenzen is trading on 36.9X

ChiNext is trading on 97.2X

Today we take a look at IPO activity.

Market capitalization is rising faster than SHCOMP due to the increased volume of IPOs.

June MTD China announced IPOs total over 75 billion USD (as at 26 June). This compares with an average of 27 billion per month for the last 12 months.

We estimate the 12 month cumulative IPO volume as a percentage of market capitalization in the second chart below*. IPO volume is definitely diverting capital away from the market.

Chart 1: Normalized Market Cap, SHCOMP and IPO issuance.

Chart 2: IPOs as a percentage of Market Cap. 12 month moving sum.

Bondification. The Quest For Yield And The Turning Point.
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When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).

We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.

Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.

The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.

It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.

As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.