Greece: The Tug of War Continues
The referendum called by Greek Prime Minister Tsipras on the proposals by the "institutions" (IMF, EU and ECB) is effectively a vote on euro membership. Our base case is that Greek voters will support staying in the euro. Political change and an agreement with creditors on a multi-year extension of the bailout program are then likely to follow.
After months of negotiations, Greek Prime Minister Tsipras rejected the "final" package of measures proposed by the "institutions" (IMF, EU, ECB) on Friday night and called for a national referendum, asking the voters to endorse his rejection. (The question put to voters will be: "Do you approve/agree with the latest proposal of the Institutions?") Meanwhile, the Greek parliament has formally approved holding the referendum, with the opposition parties voting against it. To hold the referendum, some emergency legislation has to be approved. There is still a small probability of a last minute about-face, i.e. a cancellation of the referendum, either due to logistical problems or because negotiations with the creditors are started again and concluded successfully. However, we regard this as unlikely.
Base Case: Vote in Favor of Creditor Proposal and the Euro
While the Greek government claims that a vote on the proposed measures is not equivalent to a vote on euro membership, we think this link is in fact quite a direct one. It seems very unlikely to us that the creditors would make further concessions to the current government, given that it has recommended a "no" vote. In case of such a vote, the Greek government would thus be cut off from urgently needed external funds. It would therefore quite likely have to resort to issuing
Electoral Arithmetic Favors Pro-Euro Vote
Given the recognition that a return to a national currency would imply severe economic hardship, we believe that Greek voters will favor the proposals of the creditors, i.e. vote against the recommendation of the government. The severe cash squeeze that is likely to follow in the coming days (see below) is also likely to reinforce the pro-euro stance. Voter arithmetic also suggests this: the yes vote will unite the fragmented centrist opposition that together accounted for 40% of the vote in the 2015 election (Pasok, New Democracy, Potami and a centrist party outside the parliament). In addition, a significant segment of Syriza is strongly pro-European, and while extreme right wing voters might go with the government, parts of the Communist party favor Eurozone membership. Finally, we would expect a strong and well-funded campaign by the pro-euro parties.
Negotiations Continue Despite the Referendum
The near-term outlook for consumer and business sentiment in the Eurozone likely depends on the outcome of the Greek referendum on 5 July. Particularly a refusal of reform measures and a heightened risk of a Eurozone exit of Greece – which is not our base case – could potentially cause more doubts about the outlook of the Eurozone recovery, potentially holding back consumption and investment growth in the short term. Despite the small size of its economy, the crisis in Greece has thus the potential to negatively impact Eurozone's growth. Still, with other sentiment indicators (such as the Purchasing Managers' Indices for June) having proved to be quite resilient despite the lengthy negotiations with Greece, and given that Greek voters will very likely vote in favor of remaining in the euro (our base-case scenario), we think that the current episode of heightened uncertainty is unlikely to derail the Eurozone recovery.
Medium-Term Solution for Greek Banks Depends on Referendum
Our main scenario includes the acceptance of the referendum or, in the worst case, new elections in Greece after a prolonged period of uncertainty. Most important for banks (sector rated outperform) is the longer-term continuation of ELA funding. As a result, the European Central Bank (ECB) remains the main regulator for Greek banks in close coordination with the national regulator. As was the case in Cyprus or Ireland, a consolidation of the Greek banking scene into a "good bank" and a "bad bank" would be an option to pursue in the medium term. Deposits over EUR 100,000 should remain protected, while a recapitalization is most likely.
Base Case Post-July 5: Pro-Euro Coalition to Take Over
Even if Greek voters vote against the government’s recommendation and in favor of euro membership, a period of political uncertainty is likely to ensue. However, especially if the verdict is clear, we would expect a pro-euro coalition of some sort to emerge over the coming days or weeks.
Base Case Post-July 5: The Bailout Program to be Extended
Following the formation of a new government, we would assume that negotiations with the creditor institutions will be rapidly re-launched and completed. The result would likely be an extended program covering the next 2–3 years; it would encompass a combination of significant reforms in return for financial support. A key issue to address would be the Greek banks as their non-performing loans are too high. We would expect the next bailout program to thus include significant funds for bank recapitalization. In this context, our banking analysts also believe that a "bad bank" may be set up to clear the banking system of non-performing assets.
The Risk Case: Grexit and Potential Longer-Term Damage to the Euro
While Greece is a small country with very limited direct impact on the overall European economy – its Gross Domestic Product is approximately 2 percent of the Eurozone total – we believe that the July 5 vote is of considerable significance for the future of the Eurozone as a whole and for the euro. We do not adhere to the view that a Greek exit from the euro would strengthen the cohesion of the currency. We would rather see this as a potential long-term risk. The exit of one country could be interpreted by markets as the "beginning of the end."
The Risk Case: The ECB Response Would Limit Contagion
That said, and as laid out below, we would not expect a vote by the Greek population against the creditor proposals to produce an immediate threat to overall Eurozone stability. In fact, it seems likely to us that the ECB would step up efforts to maintain stability in the euro area, and specifically to support other periphery countries and markets. Such support would ultimately also be provided to Greece, in our view. The worst case, i.e. an exit of Greece from the EU and the euro seems quite unlikely to us given the geopolitical importance of Greece and the basic pro-European stance of the population.
Financial Markets in Risk-Off Mode Ahead of Greek Referendum
The political uncertainty of the coming days up to 5 July is likely to translate into typical "risk-off" market reactions, which generally include refuge into core government bonds. In particular, we expect US Treasury, German Bund, and Swiss Eidgenossen yields to decline as a result. Within credits, European peripheral credit spreads could widen (the extent of credit spread widening depends on the reaction of the European Central Bank (ECB)). European high yield bonds, which correlate quite strongly with peripheral European bonds can also be expected to sell off. This could transmit to US high yield and emerging market bonds, even if the latter are not directly affected. Equities would similarly react negatively to heightened risk, with high beta (risk-sensitive) equity indices like the European or even Japanese and Chinese equity markets particularly vulnerable to setbacks. Swiss equities could prove more resilient, provided the Swiss National Bank (SNB) intervenes successfully and keeps the EUR/CHF exchange rate above 1.03. On currency markets, safe-haven flows are generally supportive to USD; JPY and GBP could also benefit. Within alternative asset classes, commodities may gain support from lower core bond yields, but a stronger USD could limit gains.
Significant Impact of July 5 Referendum
The July 5 referendum will, in our view, have a significant impact on markets as it could lead to two very different states of financial market sentiment. Under our base case of a vote in favor of euro membership, we would expect a significantly positive reaction for risk assets. Most importantly, we would expect European equities to rise sharply. The largest gains are likely to be in Greek equities, followed by other periphery stock markets. Meanwhile, core bond markets would likely decline, with yields up while spreads for periphery bonds and other higher risk bonds would narrow. Safe-haven assets such as gold would decline. The euro would likely make some short-term gains, but the medium-term depreciation trend would, in our view, be re-established once market focus turns back to the US Fed – note that a resolution of the Greek crisis also makes a Fed hike more likely at the margin and thus would confirm our scenario of monetary divergence. Finally, we would expect CHF to depreciate. A weaker EUR and CHF would add support for the DAX and SMI.
Grexit-Scenario: Quick Reaction From the ECB Expected
In the risk scenario, i.e. a vote against euro membership and subsequent Grexit, we would likely see additional short-term setbacks in European risk assets, especially in the periphery, with additional flight to quality. However, we would expect a relatively swift reaction by the ECB in the form of additional verbal intervention as well as, possibly, added quantitative easing (QE). This would support periphery markets. That said, the precedent of Grexit could limit spread convergence. It would also add a permanent risk premium to periphery markets, including Portuguese, Spanish and possibly French equities as well. The euro would weaken, in our view, which would support German stocks in relative terms. Note that negative demand effects from Greece are very small. Core government bond yields would remain low for longer.
Investment Strategy: We Continue to Favor Eurozone equities
The Credit Suisse Investment Committee recently moved Eurozone equities to overweight in full recognition of the fact that uncertainty in Greece could increase in the short term. Our view was – and remains – that even a Greek exit from the euro would not fundamentally undermine the Eurozone economy because the ECB would step in to protect the periphery. Our USD-bullish view, overweight in Swiss equities and, within fixed income, our neutral view (previously underperform) toward government bonds help to mitigate temporary losses. Our base case remains a pro-euro vote and a sharp recovery of European equities, combined with setbacks to core government bonds. To investors who have excess cash holdings, a temporary sell-off in riskier assets would, in our view, provide the opportunity to deploy cash into equities (with our preferred regions: Europe, Japan and Switzerland).
Implications for CHF, Swiss Interest Rates and Swiss Equities
We expect the SNB to counter any excessive appreciation pressure that might result from the Greek crisis. This may at first be through verbal and FX interventions (likely ahead of the Greek referendum). But, if required, the SNB could consider lowering its 3M Libor target into even more negative territory than currently (e.g. in case of a Grexit scenario). The SNB has shown repeatedly that it makes monetary policy changes between regular meetings if extreme circumstances require it. Volatility in EUR/CHF could hence be capped by SNB interventions, but lower Swiss interest rates would likely follow suit. Provided the SNB successfully defends the Swiss franc, Swiss equities should hold up reasonably well. Only in the low probability event of capital controls being introduced in Switzerland in response to excessive capital inflows or in the case of an unsuccessful defense against CHF appreciation, would the Swiss equity market suffer on a relative basis. A return to an explicit FX target seems relatively unlikely at this time. The new member of the SNB's Governing Board, Andréa Maechler, who commences her new functions on 1 July and joins the SNB from the International Monetary Fund, may well introduce a more FX-QE friendly voice into the SNB Governing Board. But a reintroduction of an exchange rate policy would be too meaningful a U-turn to be implemented without other changes in the Governing Board. So we view this as relatively unlikely in the short term. However, if Q2 GDP data in Switzerland are indicative of a recession later this year, such a policy stance could re-emerge.