Even with the election behind us, there are still many unanswered questions. Will the newly formed coalition government of Syriza and the Independent Greeks provide stability, given the limited overlap in their policies? How will negotiations with the Troika play out, and will Germany concede to a write-down in loans to Greece?
Market reaction to the election result was initially subdued, with opinion polls showing a likely Syriza victory had given markets time to adjust to the anticipated result. There is still plenty of uncertainty surrounding Greece, but the threat of the country leaving the eurozone is greatly diminished. What is more, fears of contagion affecting other countries is not being reflected in bond markets, as shown in the chart below. This rather sanguine attitude towards a Greek exit is itself a little unnerving. While the probability of a ‘Grexit’ may be low, it is still a possibility.
The markets’ more relaxed attitude could be attributed to the relatively stronger state of the eurozone economy, which is now further through the business cycle than in 2012. Meanwhile, European institutions have introduced a raft of measures designed to reduce the systemic risk in the single currency bloc and significantly lower the threat of contagion. The most powerful is the quantitative easing programme initiated by the ECB. This bond-buying scheme should help raise inflation expectations in the region, boost economic momentum and reduce the exposure of periphery bond markets to rising levels of volatility. While this could help allay market fears, it is unlikely to absorb all of the expected political posturing from both sides as the negotiation process begins.
The negotiations over restructuring the bailout agreement will be the focus in the immediate future and are likely to create plenty of tension. Syriza campaigned on redefining the austerity measures imposed on Greece and wants to enter into fiscally expansive policies which go against the current bailout agreement. A speedy negotiation process between the Troika and the new government would be the best solution both for Europe and for markets, especially if it reinforces the importance of economic reforms that are desperately needed for long-term economic growth.
It is possible that prime minister Alexis Tsipras may become more pragmatic due to the economic, financial and banking pressures from within Greece itself. The government will need to repay €8.5bn (£6.3bn) in loans to the international monetary fund this year, as well as €6.7bn (£5.0bn) of market debt owed to the ECB by around the middle of the year.
Meanwhile, Greek banks will need to ensure they retain their access to ECB financing. Without the backing of the ECB, Greece could be exposed to significant risks. The ECB’s recent QE announcement included Greek sovereign debt, stating that non-investment grade bonds would only be eligible for purchase if those countries remained within financial aid programmes. But the most pressing threat the country faces is that Greece’s banks rely on the ECB’s emergency liquidity assistance following the sharp increase in outflows of deposits from the national banking system. There is also a risk that a silent run on banks may already be under way.
Investors who hold Greek assets could be the biggest losers from the outcome of the election and the extended period of market uncertainty that it may create. This will be especially true if Greek banks continue to face liquidity constraints as depositors take money out of the financial system.
Political uncertainties will remain a headwind for European markets, despite signs of an improvement in the economic backdrop. European growth could surprise on the upside this year, supported by a weaker euro, falling energy costs and the low cost of household and corporate borrowing. However, investors should not discount the potential for broader political tensions within the eurozone to cause volatility in the months ahead.
Kerry Craig is global market strategist of JP Morgan Asset Management
