There are three inter-connected problems in peripheral Europe: a) most serious, a loss of competitiveness (ex Ireland) that we think requires more wage deflation than the economic consensus forecasts; b) excessive private sector debt and c) high public debt, where a haircut of 36%, 25% and 32% is probably needed in Greece, Portugal and Ireland. Our base-case scenario is that this is not a systemic risk (as the cost to core Europe of not bailing out peripheral Europe is at least 2x the cost of bailing it out), Spain (which is 12% of European GDP) does not require a haircut and the ECB will endup repo-ing more and more peripheral European debt to offset deposit flight
We believe there is a 75% probability of a delayed and 'agreed' default in Greece: a roll-over of government bonds will be implemented, allowing GGBs to be used as collateral with the ECB, with restructuring being postponed until Greece runs a primary surplus, banks are better capitalised and the ESM is set up.
We believe there is a 15% probability of a unilateral default within six months, but this would be met by a quick European policy response. In this scenario, European markets are likely to fall 10% but offer an attractive buying opportunity (as the ECB will likely have to do QE).
Lastly, we see a 5% probability of a unilateral default with a poor European response, a break-up of the Euro, a 5% fall in European GDP and a 20% decline in markets (and a 5% probability of Germany withdrawing from the Euro).
Leaving the Euro-area would just be an expensive way to default: if any peripheral European country left the Euro, we estimate GDP would fall by 20% or more (owing to the relianceon ECB funding and the need to tighten fiscal policy, as all these countries are running primary budget deficits).! Investment conclusions: buy domestic Germany (eg, Deutsche Wohnen, Commerzbank); stay short of domestic plays in peripheral Europe (eg, FCC, Brisa); buy Italy (eg, Enel): it looks abnormally cheap and should not be considered part of theperiphery, in our view; the euro could easily weaken to Eu/$1.35; banks do not offer sufficient appeal until they trade 10% lower (we are overweight the life companies); and we stay underweight Continental Europe.
We believe there is a 75% probability of a delayed and 'agreed' default in Greece: a roll-over of government bonds will be implemented, allowing GGBs to be used as collateral with the ECB, with restructuring being postponed until Greece runs a primary surplus, banks are better capitalised and the ESM is set up.
We believe there is a 15% probability of a unilateral default within six months, but this would be met by a quick European policy response. In this scenario, European markets are likely to fall 10% but offer an attractive buying opportunity (as the ECB will likely have to do QE).
Lastly, we see a 5% probability of a unilateral default with a poor European response, a break-up of the Euro, a 5% fall in European GDP and a 20% decline in markets (and a 5% probability of Germany withdrawing from the Euro).
Leaving the Euro-area would just be an expensive way to default: if any peripheral European country left the Euro, we estimate GDP would fall by 20% or more (owing to the relianceon ECB funding and the need to tighten fiscal policy, as all these countries are running primary budget deficits).! Investment conclusions: buy domestic Germany (eg, Deutsche Wohnen, Commerzbank); stay short of domestic plays in peripheral Europe (eg, FCC, Brisa); buy Italy (eg, Enel): it looks abnormally cheap and should not be considered part of theperiphery, in our view; the euro could easily weaken to Eu/$1.35; banks do not offer sufficient appeal until they trade 10% lower (we are overweight the life companies); and we stay underweight Continental Europe.
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