Sweetwood Capital
Monthly Market Insights
A Denouement for Greece?
Global Markets
Performance
Newsletter n°39
Once again, the Eurozone is in the crosshairs of financial markets.
Taking a step back, it is peculiar that a country whose GDP is less than
that of Dallas, Texas, with a population less than Istanbul should hold
markets captive. Still, Greece’s technical default on a $1.7 billion
payment to the IMF is another reminder of the still large imbalances
that exist in Europe’s single monetary union and the structural issues
that are likely to remain regardless of whether Greece remains a
member state.
That being said, our core views remain intact: principally that equity
markets have not yet made their highs for the year; that the U.S. dollar
will continue to appreciate on a trade-weighted basis; that Japanese
equity markets will outperform their developed market peers; and that
high yield credit will deliver mid-single digit returns in the face of rate
normalization in the U.S.
These views are supported by our belief that the Greek situation will
remain relatively contained without the spill-over that was witnessed in
the summer of 2012 when spreads on peripheral debt rose to 605bp for
Spain (currently 149bp) and 1336bp for Portugal (currently 220bp).
The differences between then and now are material, namely as a result
of the continent’s stronger banking sector. According to the Bank for
International Settlements, as of year-end 2014, total foreign claims of
the European banking sector against Greece were $33 billion compared
to its peak of $300 billion in 2010. In addition, the four systemically
important Greek banks have more than 90% of the market share,
meaning that European banks are fairly insulated from the arrears
which are likely to pile up. What’s more, public institutions including
the European Financial Stability Facility (EFSF) and IMF, as opposed
to the private sector, now hold the majority of Greek debt.
1
The European Central Bank (ECB) is also better equipped to prevent
financial market contagion. First, it is already in the midst of a 60
billion euro per month asset purchase program—better known as
quantitative easing—which it could tilt towards the purchases of
more peripheral debt if spreads blew out. In a more adverse
scenario, the ECB could also rely on the still untapped Outright
Monetary Transactions (OMT) which were announced at the height
of the eurozone crisis in 2012 and allow the ECB to purchase
sovereign debt. In June 2015, the EU Court of Justice ruled that this
program did not exceed the powers of the ECB in relation to
monetary policy, meaning that in an extreme scenario, extreme
measures are at the disposal of the ECB.
Despite a more robust backdrop, we are prepared for heightened
volatility and equity market weakness as investor sentiment is
subject to the most recent headline or rumour out of Brussels or
Athens. It is also important to acknowledge the difficulty in
predicting political outcomes in Greece, especially at they relate to
the durability of the Syriza government should Greek citizens
support the series of reforms contained in the July 5 referendum. A
“no” vote will surely increase economic instability and make it more
difficult for the IMF and Europe to provide additional support to
Athens as it will be seen as a vote against EU membership.
Still, we believe it is important not to lose sight of the underlying
economic fundamentals in Europe which have improved over the
last three months. This partially accounts for the rapid move higher
in 10-year German bund yields which are pricing in a better growth
outlook and rose from a low of 0.049% to around 0.760% at the
time of writing. In June, eurozone PMI numbers also showed broad
based improvements while credit growth continues to expand. We
expect this will translate into higher earnings for European
corporates which are already estimated to grow more than 10%
compared to last year. The tailwind associated with a lower euro,
which we expect will revisit its lows seen earlier this year will also
propel earnings. European indices continue to trade at more
attractive valuations than their U.S. counterparts and are in a less
mature part of the earnings cycle, further strengthening our
conviction on a relative basis.
Moving away from Europe, it is important to consider the
second-level impacts that the Greek situation could have on other
markets. While the decision of the Federal Reserve on whether to
begin hiking rates is not likely to be driven by Greek events, a rapid
appreciation of the U.S. Dollar amid a flight to safety would
effectively tighten monetary conditions in the U.S. and could lead
the Fed to reassess its timing. This is not our base case and we
continue to bias our outlook on the timing of hikes, like the Fed, on
incoming data.
The most recent data from the U.S., including retail sales and
housing starts, is pointing to a stronger second quarter and is
strengthening the case for hiking rates in September. Still, the
market is evenly split between then and a December hike. This
decision will largely depend on the U.S. consumer, which accounts
for around 60% of U.S. GDP and who is slowly starting to spend
some of the savings accrued from lower energy prices. Regardless of
when the Fed hikes, we continue to believe the path and destination
of rate increases (the so-called dot plot) is of greater importance.
2
Asset Allocation
Weightings
Interest rates in the U.S. are likely to drift higher as the economy
strengthens, though we expect to see a flattening of the yield curve as
short-end rates adjust to rate hikes more than the longer end. The
steepening in the yield curve this year has led to an
underperformance in investment grade (IG) credit which has a
higher duration than its high yield (HY) counterpart. For the year,
the BoAML IG Index is down 0.4% while the HY Index has returned
2.30%. We think IG credit should strengthen in the coming months
as spreads absorb the move higher in Treasury yields though we still
expect the high yield asset class to outperform year-end.
As for U.S. equities, we continue to prefer a market weight position
given loftier valuations and the combination of record corporate
profit margins and near-full employment, which could induce some
cost-push pressures on profits. That being said, we do not believe the
highs in U.S. equities have been seen yet. The market should
continue to be supported by strong M&A activity, which is up 60%
for the first half of 2015 and the low hurdle for second quarter
earnings.
Japan continues to be the best performing equity market, despite
undergoing its first monthly losses for the year. We continue to
maintain an overweight position in Japan, hedged against the yen,
given still attractive valuations, steady monetary policy support and
reforms aimed to unlock shareholder value.
MANUEL J. SUSSHOLZ
Managing Director
and Founding Partner
SAMUEL COHEN SOLAL
Managing Director
and Founding Partner
In China, the Shanghai Composite has fallen close to 20% from its
highs of the year, amid the highest volatility since 2008. Still, the
market is up 108% over the last year. The H-shares market has
emerged less scathed, down around 9% from its high, but up only
13% over the last year. We continue to prefer the H-shares market
given its discount to the A-shares market. The push and pull between
monetary expansion from the People’s Bank of China and
regulations seeking to reduce margin financing for equity purchases
are likely to increase volatility in the near-term.
This summer is shaping up to be a critical point for a number of
market developments. Markets will continue to pivot off of the
politics in Greece, incoming macro data from the U.S., and ability of
monetary policy in China to sustain the country’s equity market rally
and improve earnings. All of this is set against a backdrop of
divergent monetary policies, heightened currency volatility and
loftier valuations on financial assets which has incentived greater
risk-taking among market participants. In our view, generating
positive returns requires increased flexibility and the ability to look
through periods of higher volatility. Notwithstanding the challenges
associated with divergent central bank behavior, we believe that
opportunities also exist. In that context, risk-management combined
with rigorous sector and geographical selection will remain key
factors for investment performance. As usual, don’t hesitate to
contact us to discuss our investment views or financial markets more
generally.
Best regards,
Sweetwood Capital Investment Team
Copyright © 2014 Sweetwood Capital Ltd., All rights reserved.
3
DANIEL FINK
Senior Analyst
DINAH SAADA
Junior Analyst