Grisis… Graccident… Grexit?

Time is running out for Greece as the Euro-area backed bailout extension expires at 6pm ET and $1.8bn of payments to IMF are due. A technical default will trigger further repayment and Greece will lose $18bn in funding overnight, 60% of which comes from a Greek bank rescue fund. Greece is on the precipice of financial meltdown. If capital controls were not imposed this weekend, Greek banks would’ve exhausted reserves by early next week or sooner.

Market reaction:  Most of the contagion seems to be limited to Europe and there doesn’t seem to be an expectation of a major impact on US markets beyond the short-term sentiment driven sell-offs. In fact, US markets already saw a quick rebound this morning.

Even within Europe, the markets response was tepid compared to previous “Grisis” moments. Volumes stay compressed meaning investors aren’t panicking. European peripheral 10Y bonds widened only about 35-40 bps to Germany- a moderate move compared to the dramatic widening in 2011 and 2012.

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What’s next: 

The market response is subdued largely because the fundamentals in Europe are looking up on QE, cheap oil and lower euro. The ECB has established credibility for the markets and there is weakening of direct transmission mechanisms of contagion to rest of Europe through the financial sector.

The ECB’s policy actions in the coming weeks will depend on the extent of spillover to European sovereign debt and the financial sector.  If the ECB takes aggressive action, we could see a Euro sell-off.  Most market strategists are assigning a 30-50% probability to Greek’s exit from the Euro-zone. If Grexit does happen, the impact on the monetary union is unclear since there is no formal documentation for member removal from the monetary union. For Greece, however, the exit scenario will probably look like Argentina in 2000-01 with tightening of capital controls and a dual currency environment. Any resolution would be positive for the markets than the current situation of ongoing uncertainty which is knocking confidence down.

grisis

Our portfolios are performing as expected with respect to our target benchmarks as we have limited direct exposure to the European markets. We’re seeing an uptick in financial stress indicators and are closely monitoring the situation. The political situation is unlikely to cause us to change our portfolios drastically unless we see a corresponding deterioration in economic fundamentals.

Don’t Panic

The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?

The fundamental argument for panicking

The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.

The “fear itself” argument for panicking

Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.

Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.

The stronger argument for staying the course

At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.

In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.

Our conclusion: Don’t Panic

Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.