We all know the story. Markets go down a bit in Greek (or peripheral European or US or China or EM…take your pick) worries, then we get a resolution or more QE or both, and equity markets fly to the upside. It was therefore no surprise to see equity markets rally strongly at the beginning of last week as it became obvious that Greece would more than likely be bailed out for a third time. We have to say that we are surprised that the rally was so persistent all week as the Greek deal looks to be a bad deal for everyone and could fall apart at any time. Furthermore, the Fed (and the Bank of England) remains on track to raise interest rates before year end thereby removing, albeit slowly, the accommodative monetary stance that has supported equities for so long.
First, let’s consider the Greek deal. Lionel Barber, editor of the FT tweeted last week “Schauble, IMF and Tsipras in their own words on the Greek deal: nothing to like, less to recommend”. So European politicians don’t like the deal, the IMF don’t like it and the Greeks certainly don’t like it.
With the economy operating some 25% below the peak level in 2007, nobody can deny that the Greeks have suffered an economic crisis as bad as the US depression in the 1930s. Although nobody doubts that there needs to be reform of the labour market and tax collection has to be completely overhauled, who on earth believes that further austerity is going to help in the short term? Also, the IMF and most European officials understand that Greece requires a huge amount of debt relief including actual haircuts. For the moment, minimal re-profiling is all that’s on offer which will leave Greek debt at unsustainable levels with the IMF suggesting 170% debt to GDP by 2022.
All that has been agreed this week is short term bridge financing and the details of the third bailout will be negotiated in the near future. There is a risk that these negotiations break down before the bailout is agreed, but assuming the bailout is agreed, it is then only a question of time before fears of Grexit rise again. As we said last week, there are no winners from what was agreed and European markets risk getting ahead of themselves if they continue to go up in a straight line.
The other big problem that has weighed on confidence is China. When we discussed the anatomy of a bear market a few weeks ago, we explained that after a serious decline over a short period, the market should bounce creating what has been coined a “bear trap”, see chart below. It appears that the officially engineered rally of the last 7 trading sessions is creating such a bear trap. We expect the rally to continue a bit higher in the short term, but ultimately, the rally should fail and the market should decline by another 30% or more from current levels.
With short term concerns from Europe and China much reduced, the US equity market understandably rallied, but as with Europe, the rally was more persistent than we thought likely. With Fed officials including Chair Yellen indicating that rates will start rising by year end, we believe investors need to fully understand the tightening in financial conditions that is occurring, alongside extremely stretched valuations, modest economic growth and deteriorating performance across the broad equity and credit markets. Both marketwise and economically, the US is very late cycle and we think any near term upside will be limited.
To conclude, although we highlighted last week that markets should move higher with Europe and Japan likely leading the way, the move this past week has been perhaps a case of too far too fast. The European and Chinese problems have just been pushed further down the road in a classic extend and pretend manner and yet equity investors are chasing markets as if everything has been solved. We expect the next few weeks to be a bit more choppy than the last week as investors realise that many cyclical and structural problems remain whilst US interest rates will start to rise in the near future. This is not a great fundamental backdrop and we continue to believe that investors need to remain flexible and we advocate a more tactical approach as compared to the traditional buy and hold.