July 2015

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The Odyssey Continues...

Dave Napalo

In Homer's epic poem The Odyssey, Odysseus's journey home from Troy is said to have lasted ten years. During the journey, which was made especially challenging by the actions of Odysseus' shipmates, Odysseus had to contend with the whims of the gods, battle the Cyclops, avoid the fatal enchantments of the Sirens, and navigate between the monster Scylla and the whirlpool Charybdis. Upon returning home, he was forced to compete for his wife's affections with more than a hundred suitors (whom he ultimately vanquished). By comparison to Odysseus' journey, Greece's financial crisis is beginning to look like child's play.

As the end of June approached, an agreement between Greece and its three creditors, the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF), on a medium term financial assistance plan, although by no means certain, seemed within reach. Events in late June however, demonstrated again that the actions of mortals can have devastating unintended consequences, and that financial markets and economies, like the Greek gods of antiquity, operate by rules beyond the control of mortals. In particular, the June 27, 2015, decision by Greek Prime Minister Alexis Tsipras to call for a July 5th referendum on a potential debt agreement with Greece's creditors, an agreement that was projected to call for additional economic austerity and intensified structural reforms by a Greek economy struggling to emerge from depression, shook trust and soured relations between the parties. It triggered a cycle of events that damaged Greece's already weakened financial system and economy. Both developments have made the political and economic background for an agreement more challenging and diminished the prospects for easy solution of the crisis.

Once the referendum was called, the springtime "jog" on Greek banks turned into a sprint. The ECB exacerbated pressures by capping Greek banks' access to emergency liquidity assistance, and Greece was forced to close its banks and impose capital controls. Greek banks are expected to remain closed through July 20. Not unlike the collapse of Lehman Brothers, closure of the banks has had devastating effects on the Greek economy, which is now projected to shrink 10% in 2015; and shrinking incomes and deferred tax payments have further undermined the public sector's finances.

The call for a referendum and the voters' eventual rejection of the creditors' proposals also antagonized the creditors. As a result, the agreement that Greece and its creditors subsequently reached early in the morning of July 13 contains even harsher terms than the presumed earlier proposal. To restore the creditors' trust, Greece was required to secure parliamentary approval by July 15 of Value Added Tax and pension reforms, as well as measures triggering spending cuts in the event that the government's primary budget surplus falls short of target (potentially pro-cyclical measures that may exacerbate deflationary pressures on a weakened Greek economy). In addition, by July 22, Greece must secure parliamentary approval of reforms to its civil justice system and bank regulations.

As we write this report, Greece's parliament has approved the measures required by July 15, and that action appears to have restored a degree of trust among the parties. On July 16, the ECB relaxed its freeze on liquidity assistance to Greek banks and EU finance ministers authorized a short-term bridge loan to Greece, pending approval by the EU's member states. Both moves will relieve pressure on the Greek economy as the parties move to begin negotiations on a medium term financing package for Greece.

Nevertheless, damage caused by the events of the past few weeks will not be easily undone and may further complicate a solution of the crisis. In a July 14 report, the IMF estimated that economic turmoil since the referendum was called had increased Greece's short- and medium-term financing needs by tens of billions of euro. The economic disruptions also boosted the projected trajectories of Greece's debt and debt service in comparison to the country's GDP, raising them to levels considered unsustainable over the medium term even with effective implementation of the ambitious economic and institutional reforms called for in the July 13 agreement, which seems unlikely in Greece's volatile economic and political environment. Given these less favorable debt trajectories, the IMF report suggested that achieving a sustainable outcome would require significant debt relief, either in the form of lengthening Greece's debt maturities and the introduction of lengthy grace periods, direct transfers to Greece, or haircuts on the value of outstanding debt. Each option would be difficult for the other creditors, whose actions are constrained by domestic political considerations as well as institutional restrictions on financing instrumentalities.

Despite being more than five years into the crisis, Greece and the EU's journeys seem far from over. For the time being, the prospect of Greece leaving the Euro area, or "Grexit," appears to have diminished. If the crisis provides impetus for Greece to implement productivity and international competitiveness enhancing structural reforms, and for the EU to make additional progress towards political union and a full banking union, it may be possible to look back on recent events as important, but positive, turning points in the histories of Greece and the EU. Given the very significant hurdles facing the successful negotiation of a medium term financial assistance package for Greece and the effective implementation of such an agreement, the journeys of Greece and the EU seem perilous and we would not be surprised to see the risk of Grexit resurface.

Meanwhile, back at home...

In contrast to the stormy events in Europe, the economic scene in the United States offers a more tranquil landscape. Solid if unspectacular economic growth remains the flavor of the day. Towards the end of June, first quarter real GDP growth was revised to show a decline of 0.2 percent in the third estimate from the previously reported 0.7 percent decline. While the decline was worrisome, it follows a recent pattern of weak first quarters, often reflecting harsh weather throughout the country, which was reinforced this year by economic anomalies related to the California port labor dispute.

The June jobs report was an additional encouraging sign. Employers added 223,000 jobs over the month and the unemployment rate fell to a new cycle low of 5.3%. Moreover, consumer confidence jumped upwards in June by 6.8 points and is now back to above 100. Plans to purchase a home in the next six months remained steady at 5.9%, the second highest reading since 2014. Finally, the ISM manufacturing index edged up 0.7 points in June to the level last experienced in January, before the West Coast Port issues came to a head and the dollar was still rapidly rising. Although durable goods orders have yet to show as convincing of a turnaround, the rise in the ISM new orders index to a six-month high provides further evidence that weakness in the factory sector is fading.

Against this backdrop, the all-important stance of the U.S. Federal Reserve toward interest rates remains a focus of markets. At the conclusion of its two-day policy meeting in June, the Federal Open Market Committee voted to keep the federal funds target rate range unchanged while reiterating that any policy changes would depend on incoming data. This stance was largely anticipated. Meanwhile, the Fed downgraded its 2015 GDP growth outlook to 1.8-2.0 percent from its previously downgraded forecast of 2.3-2.7 percent. This also was not a surprise given the weak first quarter GDP result. While the Fed remains cautious, its outlook suggests that the U.S. economy has solid underlying momentum and is strong enough to withstand a first rate hike in nine years in the not-too-distant future. Accordingly, the Wells Fargo forecast continues to anticipate a rate move in September to pre-empt any potential inflationary pressures in the economy.

Chinese fireworks

As Americans paused for their traditional celebration of independence with its typical display of pyrotechnics, China, the birthplace of fireworks, set off some of their own. These came in the form of a rapid meltdown of China's stock market in recent weeks. The bursting of an equity bubble is the latest reminder of the madness of crowds, when investors seem to lose their collective senses in pursuit of riches. This recent episode brings to mind an adage too often ignored, “If something seems too good to be true, it usually is.”

China's stock market woe is the latest sign that as the Chinese economy moves from its youthful years into adolescence, and there are going to be bumpy times with which to contend. The first signs of trouble began about a year ago when property prices in an over-built real estate sector slumped and the government cut interest rates to counterbalance the weakening industry. As an alternative to buildings, investors sought out equity investments, often borrowing heavily against margin accounts to do so. As a bubble began to emerge, the government instituted regulations limiting investment on margin, but much of the damage had already been done. Now, the government is seeking ways to remedy the precipitous fall. In a country just beginning to experience the rewards of capitalism, the harsh lesson being learned is that in an open economy, rewards do not come without taking risks.

Dave Napalo is the head of Foreign Exchange Risk Management for Wells Fargo. He is based in Chicago and can be reached at napaloda@wellsfargo.com.