Value Investing

Greece On The Brink; A Return To Fundamentals? Absolute Return Partners

Greece On The Brink; A Return To Fundamentals? by Absolute Return Partners

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“In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.”

Mark Zuckerberg

Greece On The Brink

A Greek, an Irishman and a Portuguese walk into a bar and order a drink. Who picks up the tab? A German . . .

Months (years!) of upheaval in Greece have taught me one important lesson. Don’t take anything for granted in politics. The referendum scheduled for Sunday 5 July looks at first glance like it could form the climax of the Greek crisis – but with background rumblings that the referendum is unconstitutional, you never know what will happen next.

For simplicity’s sake, let’s assume that the referendum goes ahead, and let’s assume that all sides behave like gentlemen and abide by the Greek people’s verdict (not exactly a trivial assumption). What is then most likely to happen?

First, the referendum itself. The Greeks will vote on the following question:

Greek people are hereby asked to decide whether they accept a draft agreement document submitted by the European Commission, the European Central Bank and the International Monetary Fund, at the Euro group meeting held on June 25 and which consists of two documents:

The first document is called Reforms for the Completion of the Current Program and Beyond and the second document is called Preliminary Debt Sustainability Analysis.

Those citizens who reject the institutions’ proposal vote NO.

Those citizens who accept the institutions’ proposal vote YES.

However, none of the said documents have been made available to the public. Nor have they been translated into Greek, so the Greeks have been asked to vote on something many of them won’t understand. Therefore, it wouldn’t be unreasonable to assume that a large percentage of the electorate will base their vote not on what they would like to vote but on what is actually happening around them, and in that respect events favour the ‘Yes’ camp.

Take last weekend. By midday Saturday, most banks ran out of cash, creating serious cash shortages all over the country. Sunday afternoon the ECB announced that it wouldn’t raise the emergency funding to the Greek banking system. Monday morning the banks never opened and Tuesday evening Greece defaulted on a €1.6 billion payment to the IMF, only for the consequences still to be seen and felt. Whether you understand English or not, these sorts of incidents are quite serious and are likely to have a material impact on the outcome of the referendum, as many are likely to see them as an indication of things to come, if they vote ‘No’.

Therefore I expect the Greeks to ultimately accept the creditors’ proposal, although it probably won’t be a very convincing ‘Yes’ (there are too many diehard Syriza supporters for that to happen) and, subsequently, I expect (as I have done all the time) the two sides to come to an agreement.

In short, there are four reasons why I think the ultimate outcome will be that Greece will stay in the euro zone and it will remain a member of the EU2. The four reasons are:

  • Many Greeks fear (and for good reasons) that a life outside the euro zone and possibly even outside the EU could be even worse than the medicine prescribed by the creditors.
  • Nobody in Europe (other than Putin) want the Greeks to establish closer ties with Russia which may be their only option if they are forced to leave the EU.
  • The EU in general, and the euro in particular, are by far the most ambitious political projects in Europe since World War II, and it would be a massive mistake to underestimate the political desire and will to make them work properly.
  • The creditors – and Germany in particular - actually benefit from the damage that Greece has done to the value of the euro. Poor domestic demand as a result of challenging demographics have made exports the most likely way to secure decent economic growth, and a relatively weak euro has been tremendously helpful in that respect. Imagine how much stronger the euro would have been if every member country had the fiscal discipline of Germany!

One final note on Greece. Don’t take everything you read in the newspapers at face value. As we all know, the media love to create a bit of drama. If you believe everything you read, it is crunch time virtually every day. My primary sources on Greece are the Financial Times and the Daily Telegraph, and those two newspapers (and the Telegraph in particular) are infatuated with the word ‘crisis’. In reality, much of what is going on is simple positioning. Neither side wants to throw in the towel prematurely, so expect the show to go on for a bit longer, regardless of the outcome in the upcoming referendum.

That concludes my response to all those people who have contacted me in recent days and weeks, asking for my opinion on the situation in Greece. And now to something far more interesting (another weak attempt by me to be funny). Not another word about Greece in this letter.

Absolute Return Research

You should know that, in addition to the Absolute Return Letter, which we publish 11 times a year, I also write various research papers for our clients. These research papers are not usually published to a wider audience, but this month we will make an exception. If you are an advisory client of Absolute Return Partners, and you have already received a paper called The Implications of Risk On, Risk Off on Portfolio Construction, you need not read any further. You will have seen it all before.

Financial markets have in many ways behaved oddly since the near meltdown in 2008. The objective of this Absolute Return Letter is to look at whether we are finally beginning to see some sort of normalisation - as in a return to the conditions we had prior to 2008, and what that would mean in practice.

Correlation matters

Traditional portfolio theory assumes static correlations between asset classes and much portfolio construction is based on this simple assumption. The reality is very different. To see that, one needs to look no further than how U.S. equities have correlated with U.S. bonds since 1990. Whereas the correlation was positive during most of the 1990s, it was very unstable and quite unpredictable between 1998 and 2008, only to turn decisively negative after 2008 (chart 1).

Greece

Not surprisingly, as a consequence, a static 60-40 portfolio (60% in equities and 40% in bonds), which is sort of a ‘benchmark’ portfolio in our industry, has not at all been the optimal solution in more recent times it is often portrayed as. In terms of risk-adjusted returns, if only equities and bonds are at our disposal, a 35-65 portfolio has actually done considerably better since 1990.

Greece 2

Greece

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