Sunday, 27 January 2013

Don't lose hope just yet

Just before the beginning of the Davos 2013 World Economic Forum last week, Bloomberg had a good text on the faulty predictions given in the previous Davos Forum, in particular concerning the Greek exit out of the euro, and the euro failure itself:
The parade of economists and investors led by Nouriel Roubini predicting Greece’s ejection by now from the euro zone failed to appreciate the resolve of European policy makers to protect their union and the amount of pain Greeks are willing to stomach.
...
Joining him in questioning whether the 17-nation euro region was built to last and declaring Greece’s departure imminent, inevitable or in its interest were hedge-fund manager John Paulson, Goldman Sachs Group Inc. President Gary Cohn, Nobel laureates Paul Krugman and Joseph Stiglitz, Pacific Investment Management Co. Chief Executive Officer Mohamed El- Erian, Kenneth Rogoff and Martin Feldstein of Harvard University and Citigroup Inc. chief economist Willem Buiter.
Watch the video for their exact predictions:


I have to admit that in the times starting this blog (October 2011) I was in favour of an orderly Greek default, thinking that it would be best for Greece to get out in order to release itself from foreign-enforced austerity and reform the system on their own. However, after seeing what happened in Italy and Spain only a month later (the fact that neither of their governments did anything to apply the reforms and use the time given to them by the ECB's bond buying program in August '11), and after realizing that the same thing will be applicable to Greece, I was more inclined to switch to the "German point of view" and advocate strong structural and institutional reforms for Greece. 

However, what happened in March was that Greece actually did default on its debt (forcing private creditors to accept larger haircuts - €100bn, following the second bailout - €130bn - in February; see graph below), but this was far from over for Greece. As I advocated back then, Greece needed a proper market reform, with a key emphasis on achieving political stability and a firm rejection of a euro exit and currency depreciation. Staying in the euro is a painful but probably most optimal way to restore investor confidence and credibility into this depression-driven country. 

Change in approach? 

In the WEF 2013 new winds are blowing and confidence is increasing among investors: 

“I am confident that the euro zone is broadly on the right track back to financial stability and economic strength,” said Josef Ackermann, a frequent Davos attendee who stepped down last year as chief executive officer of Deutsche Bank AG, Germany’s biggest bank. “The contagion risks of Greece leaving the euro zone were too great for everyone, and European leaders are well aware that a collapse of the euro would be the end of Europe’s status as a leading force in global politics and business.” 
Betting on the euro’s longevity would have made investors money last year. Those who bought junk-rated Greek bonds in January 2012 earned 78 percent, compared with 4.5 percent for German bunds, Bank of America Merrill Lynch indexes show.
One should ask himself what is the reason for this new streak of optimism, and are the policies initiated by the ECB and the European Commission really that good to prevent another November 2011 scenario? Have in mind that in January 2012 the situation was still rather bad (with even the Financial Times predicting a soon end to the euro in December), which continued well into May and June. However, Draghi's speech in July to "do whatever it takes" made all the difference in the bond markets. What was once great uncertainty and volatility in the bond markets turned into a steadily decreasing (improving) path of bond yields for the eurozone periphery: 


Source: Bloomberg
I guess this was the kind of thing all investors were hopelessly waiting for in Europe ever since August 2011 and the first US debt limit fallout and ratings downgrade; investors were waiting for the ECB to signal greater strength in the resolvement of the immediate shocks. It is certain that markets do desire structural reforms in the longer run, but it is also true that short-term investor sentiments will necessarily drive the lending market conditions. 

Even though some are still not convinced that Greece will stay much longer in the euro (Roubini has given them a deadline sometimes in the next 5 years - a much careful prediction this time), nor that the euro itself would survive. Some see austerity, some see lack of real reforms as an eventual end to the euro project. It's hard to argue against this, since austerity is done in a completely wrong fashion, without any emphasis on labour market rigidities (sacking public sector workers just won't do it) or the regulatory and bureaucratic burdens. However, investor sentiment is a delicate creature, and an event such as a euro failure may destroy all hopes for recovery for as much as a few decades. In an ageing continent, with a risingly unsustainable welfare state system, this could be a trigger for a great deal of social unrest and new (old) conflicts. Political stability of the Eurozone, a system that became irreversible, is crucial in sustaining it. This is why it will never perish no matter how faulty were its initial foundations. 

3 comments:

  1. The only thing this proves to me is that there is no reason whatsoever in markets, especially in bond markets. It is 100% about feelings, confidence, herd mentality, and self delusion.

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    1. not so much in the bond markets as it is in the stock market..
      the stock market depends more on individual behaviour that affects market volatility, while the bond market does provide a better, more precise view of the demand for securities..
      I'm not claiming it's a perfect mechanism, but it's very good in warning investors on the riskiness of a particular asset.. they certainly reveal more risk than any stock price can tell you

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    2. This is both right and wrong. It's wrong since bond markets do tend to rely more on (and provide better) relevant investor information than to sentiments, but it's also right since the onset of the global crisis it appears that investors became bailout junkies, just waiting for a range of big bazookas to save themselves. This makes the predictions on the bond markets pretty easy to make, since they mostly became dependent on policy decisions.

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