30 June 2015
Themes For June
June was a difficult month for markets with all major equity bourses experiencing a pullback, commodities softening, government bond yields rising, and the US dollar declining. The local equity market experienced one of the largest pullbacks globally as resource stocks remain under pressure with falling commodity prices, and yield stocks declined as the post-rate cut rally faded and 10 year yields rose. In addition to this banks have remained under pressure after the results season with questions remaining as to whether we have seen the top of the cycle for the majors, and as capital is topped up and the macroeconomic picture remains soft. The other event that is fresh in our minds is the dramatic escalation of the Greek crisis, which we discuss in detail below.


Greece – The Eleventh Hour
Like the movie villain that just refuses to die, Greece was once again the source of market turmoil at the end of June as it became the first advanced economy to default on a loan from the IMF. It is worth spending some time understanding this issue, as it appears we are coming to the denouement of the current act, though there may be more to follow. The key events for June are detailed below:

4th June – Greece requests a deferral of all scheduled IMF payments to the end of the month

11th June – The IMF recalls its chief negotiators from Brussels after negotiations break down

25th-26th June – After numerous rounds both sides sound a more conciliatory tone, and negotiations continue at the EU leaders’ summit in Brussels

27th June – Negotiations break down once more, and Alexis Tsipras announces a referendum to be held on the 5th July 2015

28th June – Tsipras announces Greek banks will remain closed for a period, and the imposition of capital controls

30th June – Greece misses payment of EUR 1.6bn to the IMF and falls into arrears. The bailout extension expires.

Certainly the psychodrama taking place between the Greek and European leaders shows no sign of letting up. Below are some of the memorable recent quotes from key figures:

“The fixation on cuts…is most likely part of a political plan…to humiliate an entire people that has suffered in the past five years through no fault of its own,” – Alexis Tsipras, Greek prime minister.

“We are taking advice and will certainly consider an injunction at the European Court of Justice. The EU treaties make no provision for euro exit and we refuse to accept it. Our membership is not negotiable.“ – Yanis Varoufakis, Greek finance minister.

“Perhaps we could give them up in the short term, maybe we could say ‘let’s just give in for once’…But I say: in the medium and long term, this would damage us. It would damage us in that we (Europe) would cease to be relevant in the world, that our unity disappears.” – Angela Merkel, chancellor of Germany

“(The Greeks) should not commit suicide because one is afraid of death” – Jean Claude Juncker, EU Commission president

How did we get to this point? It seems clear that Greece should never have been admitted to the Eurozone in the first place, indeed derivatives were used to fudge the balance sheet in order to join the club in 2001. In addition Greek governments, enjoying low interest rates that did not match the structural inefficiencies of the economy, treated the state as an instrument of patronage, spending wildly before 2008. During and after the bailouts subsequent Greek governments failed to make full use of the EUR 240bn in assistance to implement meaningful structural reforms. The creditors, for their part, have loaded Greece up with an unpayable debt burden, imposed too much austerity too quickly, and have underestimated the danger that an increasingly desperate populace would vote in a radical government such as Syriza. And before the crisis erupted the Germans were more than happy to lend the Greeks money to buy German exports.

Cultural differences have come to the fore during negotiations. Why would a German worker who, after recent changes, will now expect retirement at 67, support a Greek worker who currently could retire in their 50s under Greece’s generous early retirement opt-outs? As the chart to the left shows, Greek pension payments represent a larger percentage of GDP than for any other Eurozone country. Indeed pension reform has been one of the major sticking points of negotiations. The creditors have demanded cuts worth 1% of GDP to the pension system by next year. This, of course, is anathema to Syriza’s election promise of ending what it calls Greece’s “humanitarian crisis”.


Such conflict is at the heart of the fraught negotiations. Tsipras can justifiably claim that he was elected on a platform to end austerity, that he has a democratic mandate to maintain a tough stance. However the Greek public were told that they could end austerity, and still remain in the Eurozone, that they could achieve a much better deal. This was always a dubious claim, and it seems Tsipras overestimated the creditors’ desire to keep Greece in the club. The testing of that proposition, and the brinkmanship, has only escalated during the negotiation process. This culminated with the announcement of a referendum on the bailout terms to be held on the 5th July. This may have been a more positive development if the government hadn’t also announced it would campaign for a “no” vote. It seems that Tsipras is attempting to reinforce his mandate and (in his view) strengthen his hand in negotiations. However other European leaders have their own electorates to consider. In the event it seems that the main outcome of Tsipras’s manoeuvre has been to galvanise his negotiating partners into preparing for the increasingly likely possibility that Greece may exit the Eurozone.

So what happens next? The referendum is clearly a key event for the process. Previous polling in Greece had shown 70% support for staying in the Eurozone, though support dropped closer to 50% when attached to further austerity. Snap polls show an even race. It is impossible to call, though we believe there is a greater probability of a “yes” vote to the bailout package. Voters must see that their government’s tactics are failing, and they have had a taste of the pain to come with the introduction of capital controls. Those who might vote “no” must either believe Tsipras, that they can extract a better deal, or truly wish to leave the Eurozone.

The economic situation in Greece is already dire. GDP shrank 27.4% from 2007 to the trough of 2013. For comparison Portugal’s economy shrank 9.6% through the crisis. Unemployment is at 25%. Due to capital controls there is now a EUR 60 a day limit on bank withdrawals, and pension payments have been cut. Prior to the call for a referendum the banking system was only being kept afloat by EUR 89bn in emergency assistance from the ECB. Around EUR 2bn, or 1.5% of total household and corporate deposits, was taken out in three days alone in the week prior to the referendum announcement. The ECB has denied requests for further assistance but is keeping open the line already committed. If there is a “no” vote on the 5th July it seems highly unlikely the Greeks will be able to leverage that for a better deal, and the likelihood of a Greek exit would be greatly increased. Though it has missed repayment to the IMF this month, for legal reasons it is not considered in default. However if it misses a roughly EUR 3.5bn payment due to the ECB on the 20th July it seems likely that it will be cut off from the euro system, which would cause a banking collapse.


A “no” vote will likely results in a portion of bank deposits being “bailed in” to bank equity. The government would need to start printing IOUs to cover spending obligations, eventually it would need to start printing its own currency. A new drachma would likely fall 30%-50% immediately if freely tradeable, though no doubt the government will attempt to manage its descent. This would represent a massive terms of trade, and real income, shock to the populace. Inflation may rocket to 35% according to the IMF. Sure Greece may walk away from its debt, which at nearly 180% of GDP is clearly unmanageable. However the terms of the debt are very generous. The average maturity is 16.5 years, and interest rates are very low. In fact Greece’s interest payments as a percentage of GDP is far lower than other debtor countries. A devalued currency would make Greece more competitive, but exports are an unusually small percentage of the economy, and capital would flee, so any gains would not be made quickly.

Greece's interests


For the rest of the Eurozone a Greek exit would also be impactful. On the one hand Greece is only around 2% of Eurozone GDP, and whilst it may default on its debt burden the majority of this debt is now held by public institutions, unlike in previous phases of the crisis. Immediate contagion may be limited, though perhaps markets have been overly sanguine of late. However we believe that a Greek exit would nonetheless be meaningful for the Eurozone. There is no legal mechanism for a country to leave the group, indeed it is not clear exactly how it might be enacted. If an exit it did happen it may call in to question how cohesive the group actually is, given the cultural differences between countries, and the lack of political and fiscal union to back it up. If countries such as Italy or Spain entered a new crisis at some point in the future, markets will be working under the assumption that they may be booted out.

European Banks

The worst-case scenario for the Eurozone, outside a military coup following an economic collapse, may actually be a Greek exit and subsequent economic rebound after a period of retrenchment. Though we view such an outcome as extremely unlikely. However if this did occur it may embolden movements similar to Syriza in other debtor countries. Indeed the governments of debtor countries such as Spain have had little time for Syriza as they have been through a painful restructuring process themselves and are now growing strongly, as indeed Greece was before Syriza was elected. Spain’s government, for instance, faces its own challenges from the far-left. The difficulty in restructuring is even after GDP growth returns unemployment may remain stubbornly high for some time. The suffering of ordinary people can lead to radical outcomes, even though it seems from the outside that they are finally exiting the dark, just before the dawn.

A “yes” vote in the referendum, which we believe is more likely, would very likely lead to a collapse of the government. Opposition parties campaigning for a “yes” vote may form an interim government before new elections are held. The ECB would likely step up its aid as the economy would remain a zombie for a while yet. Bailout negotiations would begin anew, as the package being put to a referendum has actually expired, though would form the basis for discussions with a new government. Volatility in the markets may therefore continue for a period, regardless of the outcome of the vote, however a “yes” vote would likely bring about a strong rally in the short-term at least. However markets may not be fully calmed until, and unless, a more centrist government is finally elected that is able to negotiate with the creditor group. This process may take months. Another potential outcome would be an extremely close vote which would leave whatever government exists after the referendum with a fragile mandate. Such an outcome seems entirely plausible, and may lead to future internal conflict.

Australia – Positive Surprise to be Short-lived?
In Australia we had mixed news. On one hand the jobless rate unexpectedly eased to the lowest rate in a year, down to 6% in May from 6.1% in April. The economy apparently added 42,000 workers. These figures were met with some scepticism by economists, however GDP also surprised on the upside at 0.9% for the first three months of the year. This was driven by greater mining output and increased inventories. However Australian workers earnt an average of 0.5% less in the three months in real terms. And retail sales have been soft, and consumer confidence declining (the Westpac / Melbourne Institute index flipped to negative in May). The inventory build is likely to be short-lived. Indeed the Westpac / Melbourne Institute Leading Index eased to just below the zero neutral level in May, pulled lower by a decline in dwelling approvals despite an interest rate cut. This suggests softer conditions over the next three to nine months.

China – Soft Data, Government Support
The soft run of trade data in China continued with May exports falling 2.5% and imports dropping 17.6% YoY. The figures continues to point to weak domestic demand, indeed the Ministry of Finance announced it will slash import duties on a range of consumer products by about half to help step up domestic spending. Despite this consumption contributed 50.2% to China’s GDP in 2014, with investment at 48.5%, an important inflection point. The overall Chinese trade balance remained at near record highs, an interesting dynamic considering our record trade deficit in Australia. In somewhat positive news Industrial output did rise 5.9% in April from the year-ago period. The government is clearly working hard to support the economy, fiscal spending was up over 33% in April, from a 4.4% increase in March. The central bank is also doing its part. In the fourth reduction since November, the one-year lending rate will be reduced by 25 basis points to 4.85% effective June 28.

United States – Looking Positive
Most data points from the US point towards a rebound from its Q1 funk. GDP numbers for the first quarter were revised from +0.2%, to -0.2% on the final revision. Consumer spending was at a six-year peak in May, rising 0.9% after a 0.1% gain in April. Consumer sentiment remains high with a final June reading of 96.1, rebounding from a drop in May, the University of Michigan reported. To put this in perspective the consumer-sentiment gauge averaged 86.9 over the year leading up to the recession. Such positive readings make sense in light of the employment market which continues to power on. Jobless claims remain at a 15 year low, with 280,000 jobs gained in May. As can be seen in the chart below the pace of jobs growth is very high by historical standards. New home sales rose 2.2% to a seasonally adjusted annual rate of 546,000 units in May, the highest level since February 2008. Construction spending was at a 6 ½ year high. All this points towards stronger GDP growth in coming quarters.

Monthly Non-farm Payrolls change (Source: Reuters)

United Kingdom – the Other Referendum
Germany is ready to work with the U.K. to prevent the latter from exiting the EU, German Chancellor Angela Merkel said after meeting with U.K. Prime Minister David Cameron. Merkel said she isn’t ruling out support for revision of the EU treaty. “Where there is a will, there is a way,” she said.

A growing trade deficit and lagging improvement in the service sector held final figures for U.K. first-quarter gross domestic product growth to 0.3%. The U.K. economy outperformed Group of Seven partners last year but has suffered lagging exports and productivity gains. However business investment rose 1.7% in the three months to March.

The Fed Stays on Track
The U.S. appears well on track for at least one interest rate increase by year’s end, Federal Reserve officials indicated at their June meeting. They projected growth for the year of 1.8% to 2% and said 2% inflation is within reach, pointing to one or possibly two modest rate boosts in the remaining months of 2015. But Fed officials lowered their interest-rate forecasts for 2016 and 2017 by a quarter percentage point, suggesting they’ve become less certain about the strength of the U.S. economy in the longer run. The markets took the meeting to be broadly dovish.

Asset Allocation
An overweight to equities still makes sense given some of the softest global growth since the financial crisis will mean central banks remain supportive, even if some are turning more hawkish. Bonds may therefore look appealing in the short term, but valuations in some sectors are at extreme levels, and volatility is likely to remain high at times, as we have seen over the last month or two. This is a crowded trade with declining liquidity providers during market pullbacks, especially in the corporate bond sector. Also it is possible that government bonds may be the locus of a future crisis, what then will be the risk free asset?

We take a cautious stance on bonds given that central bank distortion is most evident in this space, and in the medium to long term it seems the multi decade bull market may be in its final act. Equities, therefore, remain our preferred choice given valuations are not as extreme, and equities are able to reprice for inflation if and when that should arrive. Australian equities however are looking less appealing. We were overweight due to likely aggressive RBA action, which we have partly seen. It seems likely that the RBA will cut further, however the broader macro picture has deteriorated to the point where the risk reward of this stance supports a cut back to neutral positioning. Trade data and retail spending have all turned soft, and capital spending plans are basically at recessionary levels.

To keep our overweight in equities, UK equities are being increased. The UK has been through a successful fiscal restructuring. It has a surprise government majority, albeit a slim one with an unruly backbench. 30% of earnings in the FTSE comes from emerging markets, which are likely to be the most lively centres of growth in the short to medium term, notwithstanding some volatility when the Fed begins raising rates. The FTSE tends to outperform after Conservative government wins. The GBP is likely to perform well against the AUD as the BOE is on a path to tightening, whereas the RBA has an easing bias. Valuations look reasonable, with nearly 60% of companies trading more cheaply than international peers. On a price to book and div yield basis the percentage trading at a discount are even higher. The major risks come from Greece to some degree, with a larger one being the upcoming UK referendum on EU membership, though we believe the UK is unlikely to vote to leave.

Discretionary Portfolio Changes
In the Australian portfolio we executed the following trades:
In the Ausralian

In the international growth portfolio we executed the following trades:
In the international