After Initial Drama, Calmer Markets, even if Nervous, Prevail

The global capital markets responded in a typical risk-off fashion to the sharp victory in Greece for the rejection of the creditors' demands.  However, by the time European markets opened, some semblance of stability was emerging,  European equities gapped lower, but quickly began recovering.  Core bond yield fell and peripheral bonds weakened, but in a fairly contained fashion.  

In the foreign exchange market, the key axis is euro-yen.  The euro was sold and the yen bought on the initially news.  The cross briefly traded marginally through last week's lows, but also recovered to closed the opening gap.  Against the dollar, the euro approached last week's spike low near $1.0950.  It recovered toward $1.1100 before running out of steam.  

The resignation of Greek Finance Minister Varoufakis was seen as a goodwill gesture, but the issue is bigger than personalities.  Recall that Greece was cut off of aid six months before Tsipras and Varoufakis took office.  Varoufakis had already been pulled back from the negotiations, and still an agreement proved elusive.   We see many observers claiming that the referendum results makes a Greek exit the most likely scenario.  We think that once again, investors may be reducing monetary union to a set of economic relationships, and failing to appreciate the political will.  

What are the immediate next steps?  Three meetings are key.  First, Merkel and Hollande will confer.  It does appear that the "no" vote exposes some differences among the creditors.  Led by the German Finance Minister, there is a wing of the German political elite that seems willing to take the "no" vote as a desire to leave union, as many EU leaders had warned.  However, this does not appear to be Merkel's view.  Hollande and Renzi seem to want to resume negotiations as soon as possible and maintain the integrity of the monetary union.  

Second, the ECB will meet to discuss the Emergency Liquidity Assistance (ELA) and the collateral. The only reasonable decision at this juncture is to maintain the current ELA cap and not change the collateral haircuts.  Maintaining the status quo, to be sure, is not neutral,  The banks are reportedly running notes.  Without new ELA funds, there is risk of further banking problems--ATMs running out of cash with fewer operating.  

The lack of liquidity with further crush domestic businesses.  Some goods may be hoarded, but services cannot be hoarded.  The ECB is unlikely to take reduce the ELA or insist on a larger haircut for collateral without a new political agreement, which brings us to the third important meeting.  The Eurogroup of finance ministers meet tomorrow (when an emergency heads of state meeting has also been called).

It appears that Tsipras will brandish two new levers.  First is last week's IMF report that argued that to put on a sustainable path requires debt relief from Europe (not the IMF).  The second is the referendum results.  Neither together nor separately will these likely change the negotiating position of the EU and ECB.  The IMF tone may have vacillated, but it has been clear in recent months that some debt relief is necessary.  What is new is only that chose to emphasize this point on the eve of the referendum.   That the Greek people chafe and worse under austerity is also hardly news.  That they want their cake and eat it too is also not new.   

A problem with debt relief is that outside of the official creditors, Greek banks are large holders of Greek government bonds.  These bonds have lost much value.  A restructuring of Greece debt would weaken the Greek banks.  Without the ECB and EU support, there is no way to recapitalize the banks.  The link between the sovereign and the banks remains as tight as ever. The other link that Greek official have trouble recognizing is between sovereignty and solvency.  The absence of the latter encroaches on the former.  

The other significant development over the weekend, the Chinese measures to support the stock market, produced mixed results.  The Shanghai Composite closed about 2.4% higher while Shenzhen closed about 2.7% lower. Shanghai shares were up almost 8% at one point, but the upticks were sold into.  The Shenzhen Composite represents more of the lower cap shares, and many of the equity support operations, outside of the suspension of IPOs, appeared aimed at the larger cap equities.   The Shenzhen Composite finished below the pre-weekend low. 

 In both markets, the financials were the strongest sector.  In Shanghai, the financials closed 6.7% higher.  In Shenzhen, financial shares finished 2.2% higher. We are concerned that margin use is still elevated, which by some estimates is at a little more than 15% of market capitalization.  We are also concerned that on almost any metric of valuation, Chinese stocks are still rich, despite the recent sharp decline.   

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