The risk of a Greek default followed by an exit from the eurozone and the likelihood of the Federal Reserve lifting interest rates are prompting obvious concern among parts of the investment world, although there’s disagreement over just how much worry is needed about the two tail winds.
Greece’s ongoing negotiations with the rest of Europe and the International Monetary Fund about its debt repayments have dominated the headlines for the past few weeks. The country looks unlikely to be able to repay some creditors without a fresh bailout deal but there is disagreement over what it should do to qualify for these funds.
Yesterday, the Bank of Greece urged both sides of negotiators to come to an agreement, saying: “Failure to reach an agreement would....mark the beginning of a painful course that would lead initially to a Greek default and ultimately to the country’s exit from the euro area and – most likely – from the European Union.”
“A manageable debt crisis, as the one that we are currently addressing with the help of our partners, would snowball into an uncontrollable crisis, with great risks for the banking system and financial stability. An exit from the euro would only compound the already adverse environment, as the ensuing acute exchange rate crisis would send inflation soaring.”
Performance of indices over 1yr
Source: FE Analytics
Recent months have also seen a renewed focus on when the Federal Reserve will lift interest rates from their record lows, with many market participants now expecting this to take place in September. Meanwhile, declining bond market liquidity has been cited as one of the factors driven the sell-off in fixed income that has blighted the opening half of 2015.
The latest Bank of America Merrill Lynch (BofA ML) Fund Manager Survey showed that asset allocators across the global have become more cautious over June, with cash balances of their funds rising from an average of 4.5 per cent to 4.9 per cent.
At the same time, the proportion of fund managers who are overweight equities has fallen from a net 47 per cent to 38 per cent as part of a general move to reduce risk across portfolios.
Some 18 per cent of fund managers polled cited a eurozone breakdown as the biggest tail risk now facing markets - no managers mentioned this risk when asked one month earlier.
However, they are not positioning for the worst outcome when it comes to Greece: only 15 per cent think the country will leave the eurozone while 43 per cent expect a default but no ‘Grexit’; 42 expect a “good resolution” to the crisis.
JP Morgan Asset Management global market strategist Vincent Juvyns warns that the volatility surrounding Greece and its debt problems are unlikely to be heading towards a smooth, timely and positive solution.
“A potentially negative scenario in Greece is looking more likely by the day. There is a risk that investors are somewhat complacent about the likelihood of a last-minute deal,” Juvyns said.
“It is difficult to make any exact prediction, but the probability of a compromise before the end of this month is low. We may have a moment of truth in the next few days, but much remains uncertain. There is a real sense of frustration across the investor community in Europe about the lack of resolution. That said, exposure to Greek is much lower today than in the past, so contagion risk is limited.”
But it is because of this point that TwentyFour Asset Management founding partner Gary Kirk says investors do not have to panic about the problems on the continent. Kirk is one of co-managers on the popular TwentyFour Dynamic Bond and Focus Bond funds.
“Commentators continue to focus on the possibility of major contagion sweeping through the eurosystem creating long-term uncertainty. Greek politicians in many cases have been the source of a lot of these stories to further their cause, and the contagion effects do make great stories, however a lot has happened since the previous sovereign crisis in 2011 to mute that contagion,” Kirk said.
“We believe that more is to come from the EU. On Monday, for example, Mario Draghi brought up the ‘road map’ for greater European Union integration that his team are drafting. Eurozone jitters will be a great excuse to get a lot closer a lot quicker, just as in 2011. Additionally the QE programme is committed to run its course until at least September 2016.”
“So our take on the Greece situation is yes, it is an uncertain situation that understandably weakens market sentiment but once it is resolved (whether or not this ultimately results in ‘Grexit’) the determination of the EU and the ECB to contain the fracas should not be underestimated. As we get close to the pivotal point in this unfortunate scenario we expect volatility will increase and bond prices may still weaken further, but this should be viewed as an opportunity for investors – for all non-Greek product – not a source of panic.”
When it comes to the Fed’s looming rate rise, the BofA ML survey found that 54 per cent of investors expect the first one to take place in September. Around 30 per cent think it will take place in the final three months of 2015 while about 15 per cent don’t expect it until 2016 or later.
Performance of indices over 6yrs
Source: FE Analytics
James McAlevey, head of rates at Henderson Global Investors, says that the conditions are right for the Fed to start raising rates but warns that this is likely to come with considerable volatility – despite efforts to telegraph this to the market.
“Recent commentary indicates to us that the Fed is on track to raise rates in Q3. The market, however, still doubts the ability and desire of the bank to initiate a move away from emergency stimulus, choosing instead to focus on what it believes to be dovish rhetoric and persistent inaction. While the Fed has been a little slower at removing emergency policy than its initial communications would have investors believe, its direction of travel has been clear,” he said.
“We feel that the Fed has moved steadily and consistently towards the exit of emergency monetary policy ever since it discussed the idea of tapering asset purchases in the middle of 2013. It is true that the eventual tapering of asset purchases was delayed by a few months (in light of the significant volatility in the bond market following the announcement), but the eventual taper of asset purchases did commence two months later.”
McAlevey adds that the central bank’s first hike will likely be “very low” by historic standards, arguing that the Fed will head into a cycle of interest rate hikes rather than carrying out a ‘one and done’ event. He expects the bank to be less predictable in this cycle, after being criticised for a “too methodical” approach in 2004 when it lifted rates by a predictable 25 basis points at every meeting for two years.
“The FOMC [Federal Open Market Committee] is currently trying to telegraph that eventual policy tightening will be ‘slow and steady’, but in truth this is nothing more than its ‘best guess’ as to what policy rates will do,” McAlevey said.
“Financial market volatility will almost certainly be a more common characteristic of financial markets when the Fed initiates its tightening campaign. This will certainly be an uncomfortable environment in which to continue tightening, but at some stage the FOMC has to start setting policy for the economy and not for financial markets.”
With the Fed’s rate rise as well as the Greek situation, Kirk says his “overriding advice” is to not panic and to try to be opportunistic as attractive prospects arise. He believes that the situation today is less worrying that other times during the recent past.
“Don’t panic - we are not panicking. In fact each of these drivers may present us with an opportunity to improve our portfolios,” he said.
“The drivers that we face here today are a lot less scary than some of those that we have navigated in recent years! Once you sell an investment it is often very difficult to get back in; look at what you may have missed if you had panicked in 2011 in the sovereign debt crisis, or in 2013 in the taper tantrum, or in October 2014 in the volatility spike.”
