There is more than a touch of “déjà vu” in the financial markets at the moment. Yet again we are faced with speculation about a country (Greece) leaving the eurozone. Once more we are looking ahead to what seems likely to be a year of very weak growth and inflation in the eurozone. And of course we are again waiting to see what the ECB will do when it finally makes its mind up about how to react to these various issues. In our view the markets are correct to be worried about these problems – they are very real – but it remains more likely than not that the outcome will also be the same as in previous years – a “muddle through” with no dramatic progress towards better growth and inflation, but no collapse of the eurozone, no country leaving it, and no severe recession either.
Before explaining why we think the ‘muddle through’ scenario is the most likely, it is useful to take a look at recent developments as in some ways the situation that European authorities face now is as serious as anything seen at the height of the eurozone fiscal crisis in 2011/2012 – with the major difference being that financial market sentiment, so far, is dramatically more positive now than it was then.
Firstly, we focus on Greece. As readers will be aware, the failure of the Greek parliament to elect a new President in three attempts last month forced the government to call early elections, in what was in effect a major victory for the opposition. The leading party in all opinion polls is “Syriza”, a left-wing and relatively new party. Until very recently it would also have been described as an ‘anti-European’ or ‘anti-euro’ party, and it can certainly still be called an anti-austerity party. Syriza’s gains in popularity have been driven by the austerity policies implemented by the governing political parties, which policies in turn were largely forced on the government by the troika after Greece was the recipient of a large bail-out from the IMF, European Central Bank and other European governments. In practice those policies would have had to be implemented in any case but the troika has been blamed for the very severe cuts in spending that have been implemented during the crisis period.
Although Syriza is expected to win only about one-third of the votes, that share is expected to be significantly larger than any other party. And, crucially, Greek electoral law gives a large ‘bonus’ allocation of seats to the largest party in the election, which means that Syriza is likely to have almost enough seats to form a government by itself.
What makes all this so important is that Syriza has had policies that are very anti-establishment (for want of a better phrase). It believes that the solution to Greece’s fiscal problems is for lenders to Greece to write off large amounts of the debt, and until recently at any rate Syriza has seemed to want Greece to leave the eurozone entirely. It is adamantly opposed to the various austerity policies being implemented by the current government. On the face of it, this is quite dramatic, particularly the desire to leave the eurozone. If that still is the Syriza policy (more on this later), and if Syriza does win the election as expected, it would mark the first time that any eurozone country has been led by a party that supports exit from the eurozone. Even at the height of the eurozone fiscal crisis in 2011/2012, every eurozone government was adamantly and absolutely opposed to their country leaving the eurozone.
An exit from the eurozone would certainly be extremely messy – there are no provisions in European law to allow it, and it would involve the creation of an entirely new currency, as quickly as possible. In all likelihood, the banking system or large parts of it would collapse and/or need huge taxpayer bailouts due to the mismatch between euro denominated liabilities and drachma (if that was the new currency’s name) denominated assets, and there would be a degree of chaos for some weeks in the interim period with a massive hit to economic activity in Greece. Internationally, a Greek exit from the eurozone would surely bring more pressure on other peripheral countries in the zone, such as Portugal, Cyprus, Ireland, maybe even Italy and Spain, as if one country left the euro, others might be thought to be at risk of doing the same. We would expect an extremely negative market reaction to such a development, one which might make the previous eurozone fiscal crisis look quite mild!
ECB grappling with difficult issues
Meanwhile, “back at the ranch”, the European Central Bank continues to struggle with dangerously low inflation and economic growth across the eurozone as a whole. It seems reasonably clear that if inflation, in particular, falls further from here, the ECB will take more drastic actions to boost growth, inflation, and confidence. The most likely option is that it will inject cash into the economy by buying government bonds, in the first half of the year, in effect printing the money with which to buy them.
However, the Greece situation is an unwanted complication for the ECB. If Syriza wins power in Greece, it will put huge pressure on Greece’s creditors to write off all or part of its debts. And the ECB happens to be a large creditor of Greece as it owns, directly or indirectly, a large quantity of Greek government bonds (Greek government bonds are no longer investment grade, so many private sector investors no longer buy them). Thus the ECB is currently trying to reach a decision on whether to buy large quantities of government bonds, at exactly the same time as it is being asked (by Syriza) to accept large losses on the Greek government bonds that it already owns. That is a complication that the ECB – and all of us in the eurozone, perhaps – could really do without, and that might well prevent or substantially delay the introduction of further ECB measures to help the eurozone economy.
Muddle through still the most likely outcome
However, we should not get too carried away by all the seemingly bad news. As we stated at the outset, we do NOT expect the situation to deteriorate very rapidly in the months or weeks ahead, notwithstanding the sometimes grim-looking outlook. There are a number of factors which will combine to make another year of “muddle through” more likely than a year of crisis:
- In Greece, Syriza has significantly toned down its anti-European rhetoric in recent months. Most likely this is reaction to the realisation that it may very well soon be in power, and will have to make difficult choices in government. It would not be the first opposition party, in any country, to become much more pragmatic once in power (or getting very close to it) than it was in opposition. Now the party says that it is now not in favour of a Greek exit from the euro, assuming that a debt relief deal can be done, which appears to be a marked change in policy.
- More than 70% of Greeks, in a recent opinion poll, want to remain in the eurozone, notwithstanding the tough austerity policies that have been perceived as being imposed by eurozone, and especially German, political leaders.
- While Syriza is the leading party in all opinion polls, it is still getting only about a one-third share of support in those polls – far from an overwhelming mandate to discard conventional economic policies and/or exit from the eurozone.
- At the ECB, although the financial markets are impatient with the pace of the ECB’s reaction to negative economic news, it seems fairly clear that the ECB will significantly step up the pace of liquidity creation (printing money) this year, and probably sooner rather than later. Certainly it is undoubtedly unhelpful that the ECB may be forced into taking losses on its holding of Greek government bonds, at almost the same time that it may begin buying government bonds on a large scale. But what choice does the ECB really have? If it does not ‘step up to the plate’, there is a very substantial risk that inflation will fall into negative territory, and remain there, dragging economic growth down after it. The only way that we can see the ECB not becoming much more radical in liquidity creation is if economic growth and inflation turns out to be much better than expected.
Our conclusion, therefore, is that 2015 will be a year of (even) greater volatility – and action - in the eurozone than was 2014, in terms of politics and policy. But as has been the case for several years now, the authorities will do enough to prevent that volatility and uncertainty translating into a full-blown crisis. In the next couple of days, Noel O’Halloran, our Chief Investment Officer, will publish a separate blog outlining what this scenario means for asset allocation in 2015.
Eoin Fahy, Chief Economist, Investment Strategist