Perfect Storm: Part 2

It's happening again. A global feel of "risk off" which is actually the sum of separate regional issues rather than a single global world shaker.

Europe now - Greece Back, Spain constant and a socialist whiff in the air. Socialist? Or perhaps just more bipolar. While right wing behaviour is easily tagged as "selfish", socialist behaviour is seldom considered such. However, TMM would wager a friendly fiver that the current wave of European socialism is about sharing someone else's wealth rather than their own. With Germany the "sharing" target of most European socialist's eyes, it is hard to see Germany following suit and moving left rather than right. At least not before the SPD win next year's election...

And who has just reappeared? Yes, that Gollum of Europe, Greece, and just like his Lord of the Rings role, this weak creature is back to twist and manipulate, follow and haunt the once strong and wise of Europe on their quest to save the Euro.

Amongst the Grexit paranoia and panic that has begun to build, TMM offer a few thoughts:

1) From the IMF/EU/ECB/German point of view, the direct cost of refusing to compromise, resulting in Syriza's reneging on the bailout agreement and defaulting is exceptionally high:

a) 70% of Greece's debt is now made up of official loans already disbursed: EUR 140bn.
b) The ECB owns EUR 40bn of Greek bonds.
c) Greek banks currently repo EUR 140bn with the ECB.


A Greek debt moratorium would thus impose exceptionally large losses on international creditors directly. To the above, the indirect costs would also be material as there is not a sufficiently large firewall to prevent the spread of contagion, nor do the Bundeathstar and EU policymakers more broadly truly appreciate the potential for contagion to accelerate beyond their ability to contain it. The magnitude of a such a sufficient policy response is just not even close to getting on the radar yet.

But even ignoring contagion, the direct costs are enough to blow up the ECB and very probably block any further IMF lending to European countries. Balancing against German arrogance/moral hazard concerns, it is not obvious that the Troika would refuse to compromise at all (despite the widely-held view that the Germans have had enough and will refuse), especially given the IMF reportedly were pushing at the last review for the fiscal consolidation to be spread out over an additional year. It is also worth noting that the cost to Europe (and especially Germany) directly would increase materially were the IMF's war chest not available for Spain/Italy.

2) The risk of Syriza ending up as the largest party - and so getting a bonus 50 parliamentary seats - is material. Assuming that they are able to attract additional support from the Left-leaning parties only (TMM don't think it is too much of a stretch to argue that the right-leaning voters are unlikely to vote for a hard Left party), and that New Democracy manage to hold onto their current level of support then on TMM's calculations a 2.2% swing from non-Syriza left leaning parties to Syriza would make them the largest party, with the additional 50 seats. That is not a massive hurdle, especially given that the momentum is now with them.

However, there has also been some dismay in Greek political and media circles at the performance of extremist parties. If Tsipras is going to be able to pick up more votes, he is going to have to seem a bit more mainstream or even more hard-left, given that the Communist party to the left of him are for leaving the EUR (he is against) and have refused to join him, while PASOK to the right of him are pro-EUR but obviously also in favour of the Memorandum. It's not easy to see whether he will pick up enough extra votes or not, but certainly very possible.

One thing that has struck TMM, in response to the German/EU statements on austerity commitment is the view that you do your homework or you leave the Eurozone. It is no coincidence that both Venizelos and Samaras have begun to try and discredit Tsipras' policy of defaulting, reversing austerity and structural reform but remaining in the EUR as a false choice - you cannot have only the good bit (EUR) without the bad bit (austerity). To reject the Memorandum is to leave the Euro.

If PASOK/ND can paint the likely upcoming election as a referendum on the Euro (to which 70%+ of Greek voters wish to keep), then the risk of an extremist government should fall, and a national unity coalition seems more likely. TMM wonder, perhaps, whether Papandreou's gambit last autumn should not have been so heavily crushed by the EU powers, for that was to be marketed as a referendum on the Euro. The Germans reap what they sow...

In light of the points in 1), should PASOK/ND manage to form a unity government, the Troika may provide a token compromise, either by relaxing a little bit or using Hollande's suggestion of a beefed-up EIB to invest in Greek infrastructure or something along those lines. TMM tend to think the latter is more likely.

3) Should Syriza manage to become the largest party, then despite Tsipras' desire to keep the Euro but default on everything, TMM reckon that a Euro exit would likely become inevitable - not out of choice, but as an "accident" arising from the following course of events:

1. Troika refuse to back down on austerity.
2. Default on ECB/Troika causes a lot of name calling & anger in Europe and elsewhere.
3. Bank runs in Greece accelerate further.
4. The ECB refuses to accept defaulted debt as collateral, cutting off the Greek banking system.
5. The inability to access the ECB window means that de facto Greece is no longer part of the monetary union, it merely uses the Euro (like Montenegro).
6. The resulting EUR140bn funding shortfall forces a sudden stop in the Current Account
7. Imports collapse as payments cannot be made due to bondholder court judgements freezing payments.
8. Food/fuel shortages, power goes off... riots move to a far more severe intensity. Perhaps the Army seize control, TMM do not know... but it seems reasonable to assume that during the political chaos a Euro exit would seem inevitable.

TMM's personal view is that a compromise of sorts will eventually be made because the costs in this gigantic game of chicken are astronomical on both sides, with some form of unity government formed that has a small bone thrown to them. It is paramount that ND/PASOK portray a new election as a referendum on Euro membership. And we should monitor the press over the coming weeks to check this. If the discourse in the media does not take this form by a week or so before the election, then TMM fear that Syriza will be able to consolidate its position and pick up the extra votes needed to become the largest party.

What to do? In the case of Syriza becoming the largest party, TMM will look buy a ticket to the theatre, buying downside in S&Ps and shorts in EM. TMM do not think trying to trade European assets directly is the right thing to do here given a lot is priced into them, and there are many uncertainties around capital controls and other legal aspects.

Should the discourse move towards Euro membership, then TMM do think it's worth trying to fade some of this Grexit paranoia. In the meantime, given that Equity Long/Short guys do not seem particularly exposed to risk (and large net-longs from this investor base have typically been seen into the larger risk aversion events since 2009)- see the Russell performance yesterday), increasing open interest in Eminis into the sell-off (argues either or both of gross book expansion beta hedging and new shorting) and general excitement on the IBs about range breaks that in the short term it looks a bit overdone to us.