Another Act In the Greek Drama

Another Act in the Greek Drama, the Euro, and Germany? March 27, 2010, Bill Witherell, Chief Global Economist

It looks like the eurozone has emerged from the latest act in the Greek sovereign-debt drama in rather better shape than many commentators (not including Cumberland) had predicted. Agreement among the 16 eurozone partners was announced during a European Union summit Thursday, March 25th, in Brussels. The deal looked doubtful at times in recent days as the major players, particularly Germany and France, clashed over contentious issues and issued statements largely directed at their domestic publics. Chancellor Angela Merkel faces strong domestic opposition to the use of German taxpayer funds to bail out the profligate Greeks. And yet she had to agree with her counterparts that any approach to the problem that would weaken the euro and the Monetary Union would result in unacceptable economic costs for the member countries, including Germany.

The Greek rescue deal involves agreement in principle on establishing a safety net for Greece. A key breakthrough was agreement that the IMF is to be given a major role (a step we have recommended). Should Greece encounter “very serious difficulties” in its efforts to refinance its large public debt on international capital markets, it would be backstopped by bilateral loans from individual eurozone governments and assistance from the IMF. Two-thirds of the funds would come from the eurozone, with the country shares determined by their capital shares in the European Central Bank (ECB). While possible amounts and interest rates have not been determined, the terms would likely be set at a level that provides Greece strong incentives to return quickly to market financing.

The ECB gave important additional support to Greece and the other highly indebted eurozone members Thursday by stating that it would not go ahead with its announced plan to raise at the end of this year the minimum credit ratings required for assets to be accepted as collateral. This removes the potential threat that Greek bonds held by Greek and other eurozone banks might not be useable as collateral should those bonds be downgraded.

Markets responded positively Friday, March 26th, to these breakthroughs, with Greek bonds firming significantly (the two-year yield at 4.435% is down 83 basis points on the week), the Athens Stock Exchange General Index advancing by 4.1%, and the euro rebounding a bit from its 10-month low, advancing almost 1% against the US dollar. In addition to eliminating the risk of a Greek default and the refinancing risk, the agreement should reduce (but not eliminate) concerns about sovereign debt stress in other eurozone countries.

Of future importance to the long-term strength of the euro is the apparent commitment to form an “economic government” for the Monetary Union, which would promote stronger coordination of economic policy. Should this come to pass and involve effective coordination of fiscal policy and of action to reduce structural impediments to adjustment, it would address the most important shortcomings in the structure of the Monetary Union.

Ms. Merkel is leading this drive, pushing for new measures for disciplining countries that persistently run excessive deficits. French President Nicolas Sarkozy seems to be putting the emphasis more on cooperation and coordination. He and all other eurozone leaders except Merkel will resist very strongly any steps that would require renegotiating the Lisbon Treaty. Progress on this issue will not be achieved rapidly, but we are optimistic that the eventual outcome will be a plus for the single currency.

One investment implication of these developments is that the headwinds for eurozone equities resulting from the Greek sovereign-debt crisis should no longer be a significant factor going forward. The strength of those headwinds can be hinted at by comparing the year-to-date (March 25th) performance of the MSCI Index for Germany, a -4.29% total return, with the +8.14% total return for the MSCI Index for Sweden, a somewhat similar European country not within the eurozone. We anticipate the performance of German equities will improve in the coming months.

Recent economic data for Germany have been encouraging. Manufacturing orders are strong. The current-conditions index registered in March the largest rise ever (4.6 index points). While the March ZEW investor confidence index eased slightly, it suggests the recovery is intact. Domestic retail sales remain depressed. Fortunately, the main driving force in the German economy is exports, for which the prospects, on balance, look good. While fiscal consolidation in its eurozone partners will depress their demand for German exports, the strengthening global economic recovery and the recent weakness of the euro should be more than offsetting positive factors. The World Trade Organization just released its projection of a strong rebound in international commerce, a 9.5% advance in global trade in 2010, following a 12% drop last year.

Our International and Global Multi-Asset Class all-ETF Portfolios get exposure to the German equity market with the iShares MSCI Germany Index ETF, EWG. The index tracked by this ETF seeks to capture 85% of the publically available total capitalization of the German market. Its largest holdings are Siemens (9.62%), the major energy firm E.ON (9.36%), Bayer (7.35%), Allianz (7.11%), BASF (6.94%), Daimler (5.03%), SAP (4.95%), and Deutsche Bank (4.78%). These are firms that can take advantage of the expected strong advance in world trade.

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