Kohler's Week: Letter from Greece

Last Night

Dow Jones, up 0.12%
S&P 500, up 0.24%
Nasdaq, up 0.71%
Aust dollar, US78.2c

Greece: investment opportunity?

I left Athens a bit excited I must admit. I went there expecting misery and pessimism and, sure, there was plenty of that, but you know what? There’s plenty of the opposite too. In fact this could be one of the great turnaround investment opportunities in history.

Of course, there’s risk, but to an extent it’s measurable and comprehensible. The extent to which it is unknowable has to do with human behaviour, as it always does, and it’s true that some of the characters in the long-running Greek tragedy, specifically those in government, are at the extreme end of unpredictable.

And yet … the most likely scenario is that Greece not only does not default or exit the eurozone, but it becomes the tiger of Europe, a fast-growing economy and possibly even one of the fastest growing in the world. I know that sounds like an outlandish over-statement given the uncertainties and gloomy commentary in the mainstream media, but actually you should take most of that with a grain of salt. Greece’s future is binary: either it collapses entirely and enters a short brutal depression far greater than the 25 per cent GDP and national income contraction of the past six years, probably with more political and social disruptions thrown in, or it survives this crisis and then outperforms the rest of the Europe, and possibly the world. Mediocrity is simply not on offer, and after my admittedly short visit I think the most likely of the two scenarios is the latter. The only question, in my view, is: how likely? I mean, is it a 51/49 likelihood (a bare likelihood), or 80/20? Between you and me, I think it might be closer to the second.

It was my final day in Athens -- Thursday -- that turned me around. I’d had three days of mostly grim briefings from politicians, diplomats and business people -- the same sorts of thing you’ve been reading for months, about how Greece’s institutions are dysfunctional, the black economy is the largest and blackest in the world, the debt, at 175 per cent of GDP, is too great, the public service is lazy and corrupt, and so on. All of which is quite true, and in fact, one of Greece’s big shipping owners, Michael Bodouroglou, told me that the problem is that Greece is “socially bankrupt, not just financially bankrupt”.

But on Thursday I did three things: I had a long briefing from a senior official at the Bank of Greece, the national central bank, I visited the Dutch Embassy, where the Ambassador, Jan Versteeg, is running a startup incubator called Orange Grove actually inside the Embassy, and I visited a high-tech manufacturer in the suburbs of Athens called Theon Sensors, which exports night vision goggles and weapon sights to 50 countries. It was a good way to end my time in Greece, and as I sit here on the plane writing to you, and thinking about this poor benighted country, I’m mostly thinking positive thoughts, not negative ones.

Bank of Greece

My briefing was off the record, so I can’t name the guy, but that doesn’t matter -- the name wouldn’t mean much to you anyway. He told me four important things:

1. The four systemic Greek banks are not insolvent, but they are starved of liquidity at the moment;

2. Greece’s sovereign debt is not unsustainable (yes I know that’s a double negative, but it’s the best way to put it);

3. Greece’s wages have been cut 30 per cent across the board and it is now a “low-wage country”.

4. Sovereign default must be a political decision by the EU, it can’t happen by accident, and in the Bank of Greece’s view, no one will make that decision.

There are a few other things, but they’re the main ones. And yes, of course, he would say that, wouldn’t he? He’s a central banker trying to talk things up. But he was convincing.

1. The four systemic banks - National Bank of Greece, Piraeus Bank, Alpha Bank and Eurobank (it’s like Australia’s banking system) – were recapitalised with €50 billion last year and are now basically owned by the “troika” – the EU, the IMF and the ECB. Actually it was the Greek Government that did the recap, via something called the Hellenic Financial Stability Fund, but the money came from the troika, and since they paid the piper, they call the tune. The shareholdings of the HFSF are different for each of the banks but in each case it’s more than 50 per cent. If the ECB were to send them to the wall by closing off liquidity, it would, in effect, be sending its own subsidiaries broke.

The four banks passed two stress tests last year, the latest being by the ECB in October. And although non-performing loans represent 34 per cent of the aggregate loan books (!!), these are 50 per cent covered by provisions from retained earnings. At the end of 2014, non-performing loans seemed to have peaked.

The banks' worst decisions, in fact, were to buy Greek Government bonds, on which they have lost 40 per cent of their money. In their operations the big four Greek banks are like Australia’s big four – conservative retail banks that did not get caught in the credit boom and bust of 2004-2008 and did not do investment banking at all.

The problem is cash is draining out of them. There was a steady pace of withdrawals in 2014, a more significant outflow in January, before and after the election, and that continued in February. The pace of withdrawals slowed in March and has picked up again in April because the tension is rising again, as more and more people and companies either move their money into safer European banks or just put it under the mattress at home. This week the outflow totals €1.5 billion.

The banks rely on Emergency Liquidity Assistance (ELA) from the ECB. They put up their assets as collateral and the ECB applies a risk-based “haircut”. Six months ago the haircut was 40 per cent; currently it’s 25 per cent, but there was a story in one of the newspapers this week quoting an ECB source that they are considering increasing it again. In any case, my Bank of Greece source says there is theoretically no limit to how long this can go on for, unless the ECB decides to cut off the ELA. That, he told me, would be a “very extreme scenario”. All four banks would have to close, and the Greek economy would immediately collapse: therefore, it won’t happen.

2. Sovereign debt sustainability: the Greek Government’s debt is 175 per cent of GDP, which is very high, but almost half of it carries no interest until 2022, under the original bailout deal. Total debt is €319 billion and the zero interest (well, actually the interest is capitalised for seven years) bit is €140 billion. It means the weighted average interest on the sovereign debt is 1.9 per cent, which is OK.

There are about €5 billion in repayments due to the IMF and the ECB over the next few months, and six months ago it looked like the Government would be able to go to bond markets for this money – yields were around 5 per cent and it had issued two relatively small Treasury notes – one five-year and one three-year – to test the market’s appetite. But as soon as it became clear there was going to be another early election, and that the left-wing grouping called Syriza was a good chance to win, the markets closed and there was – and is – no hope of raising any bond market cash.

The Government has now bought time – till the end of July – by calling in the reserves of regional governments and government enterprises. The local governments have been squawking about it and everybody is seeing it as a sign of desperation, but just about every European country has done a bit of this from time to time – including the Netherlands, according to the Ambassador. So maybe it’s no big deal.

3. Labour costs: Under the brief Prime Ministership of Lucas Papademos (2011-2012), the minimum wage was cut by 25 per cent and enterprise bargaining replaced the centralised wage system. It was a momentous change: the wage cut was seen as part of the austerity program imposed by the troika, but it’s unclear whether that’s true. In any case that, plus general unemployment of 28 per cent and youth unemployment of 60 per cent, has brought the average wage down by 30 per cent over five years.

Obviously this has caused tremendous hardship, along with reductions in pensions, but it has produced a step change in the competitiveness of Greek industry. The flexibility from enterprise bargaining is almost as important as the wage cut, because it has given management back to the managers, instead of the big labour unions and employer groups.

4. But will there be a default and/or exit from the euro? Possible, but very unlikely. Having called in that money from local governments and the broader government sector, the Government can probably meet the repayments due between now and July. Also, the ECB is sitting on €1.9 billion of profits on Greek bonds that it said it would hand over, and there are €7.1 billion payments due from the IMF under the sixth, seventh and eighth reviews that were part of the previous bailout program – money that can be paid as long as certain reforms are undertaken.

It’s true that Syriza has said it won’t continue those reforms, and the ministry now seems to be composed of communists and other loonies, but both Prime Minister Alexis Tsipras and Finance Minister Yanis Varoufakis (neither of whom was available while I was in Athens – the government is keeping its head down) have said they will not take Greece out of the euro. After all, the polls show that three-quarters of Greeks want to stay in the euro, and to leave would be catastrophic for the economy, basically taking it back to the stone age. Even a Marxist wouldn’t want to be responsible for that, although maybe a Stalinist or Maoist wouldn’t have a problem.

It would also be catastrophic for Europe – less so, of course, but still terrible, and it would sow the seeds of the eventual destruction of the whole European project. Whenever any other country got into trouble, there would be a clamour for the exit.

Most importantly, Greece – and Italy and Spain and Ireland – keep the value of the euro down, and the latest Greek crisis is causing it to fall towards parity with the US dollar at the moment. That is a huge benefit to the whole European economy, but especially Germany with its manufacturing base. The last thing Germany wants is for Greece to leave because that would eventually send the euro soaring.

For there to be either a default or exit, one of the two sides of the negotiations would need to decide to do it. Even if repayments to the IMF or ECB are not met, those institutions would need to decide to make it a default, rather than letting it be a “debt restructuring”. Defaulting on any troika loan would become a general default, so all of Greece’s loans would be in default, including the ECB’s. This would trigger the end of the ELA and the banks would close and the economy would collapse.

According to the Bank of Greece, default would automatically mean exit from the euro, with drachmas having to be issued by the banks because euros would no longer be available. So the idea that there could be default within the euro, as some commentators are suggesting, appears to be wrong.

It is, in effect, a situation of Mutually Assured Destruction, like the nuclear arms balance. No one will press the button.

Orange Grove

The Netherlands' young, quite long-haired Ambassador, Jan Versteeg, decided two years to do something concrete to help the Greek economy and improve relations between Greece and his country – and northern Europe generally. He approached all the big Dutch companies operating in Greece, starting with the biggest brewer, Heineken, and tapped them for money to fund a startup incubator inside the Embassy.

He raised €450,000 and got some more from the foundations run by rich Greek shipping owners, mainly the Onassis family’s one, and put together an annual budget of €200,000, which mainly goes on rent (the Dutch don’t own the property) and three full time staff, mainly organising events and bringing in speakers and mentors from elsewhere in Europe and Silicon Valley.

There are currently 60 projects going on in the Orange Grove (named after Holland’s national colour) with 100 young Greek entrepreneurs going to work in the Embassy every day. Versteeg says it’s wonderful for the Embassy: “the average age in here used to be 64; now it’s 32”.

I sat in there for a while on Thursday and got some of the young entrepreneurs to tell me what they are doing. One is building an app that does a kind of “Trip Adviser” for children’s activities in Athens, with plans to go global, another has something “Gigalise”, which is a social media campaigning tool designed to bring music acts to Greece, because it’s so out of the way that not many bands and singers come – they are presented with a big petition asking them to come, so they usually do, and Gigalise sells the tickets (and clips them of course).

There were plenty of other great ideas being beavered away at, and not all of them apps – some tourist things, like special tour guides in Athens. Other people I spoke to in Athens said there was a tremendous startup culture going on more broadly in Greece now, with the Dutch Embassy at the forefront of it.

Theon Sensors

This is a medium-sized business on the outskirts of Athens that’s 80 per cent owned by its CEO Christian Hadjiminas, with the rest owned by staff and family. I had made contact with one of his senior staff on LinkedIn and decided to visit them – but soon regretted that decision. I got hopelessly lost, or rather the taxi driver did, burning at a million miles an hour down narrow country roads while he talked rapidly on the phone to the Theon Sensors receptionist who was trying to direct him. Nightmare.

Anyway, I got there and found an amazing high-tech factory making night vision viewers, mainly for the world’s armies. Ninety per cent of combat, they told me, is now done at night, and the soldiers need to be able to see. Theon makes a range of goggles, binoculars and weapon sights that enhance starlight, even when it looks pitch dark, by converting the available photons into electrons, massively multiplying and amplifying them and then converting them back into photons – a lot more of them than the original number. It’s very high-level physics.

This business is flying now and 90 per cent of its output is exported to 50 countries, thanks to the fall in the euro and the improvement in Greece’s competitiveness over the past few years. Christian’s problem is that customers and global banks don’t trust the Greek banks so he can’t get bank guarantees to support his deliveries. He’s had to set up trading subsidiaries in Singapore and Abu Dhabi that use local banks there.

I mention this business not because you can invest in it – you can’t – but because the backbone of the Greek economy, more than most, is the SME sector, and like the startup sector, it’s getting very hungry to take advantage of the reforms that have already happened in Greece as well as the lower euro.

I was told many times that there are thousands of businesses like Theon Sensors that are starting to flex what’s left of their muscles.

Dysfunctional Greece

Lest you think my optimism means I’ve been entirely snowed, here are three true stories I heard while I was there:

1. A businessman’s driver’s mother got cancer and needed an operation. He had to go around to his extended family and collect blood for the operation because there is no functioning transfusion service in Greece. And when she went into hospital, they had to take their own nurse. There aren’t enough nurses, so everyone takes their own when they go into hospital – either a family member or a Bulgarian woman they hire.

2. Another man’s father rented out his house on AirBnB for a small amount of money and actually wanted to pay his tax on it. He went to the local Tax Office to pay and was shuffled from booth to booth, where they asked increasingly stupid questions, such as the tax file number of the German couple who had rented the house, which of course he didn’t know. “Listen”, one of them finally said to him in frustration, “why don’t you just do what everyone else does and take your €100 and keep it”. It was simply too much trouble for them to collect the tax.

3. A fish farmer I spoke has been in court for five years, along with all the other fish farms, because 15 years ago the government decreed that fish farms could only be put in designated areas and that the areas would be designated within 10 years. After 10 years nothing happened and no areas were designated, but the law that said fish farms could only be put in designated areas had passed and still stood. That meant that, suddenly, fish farms could not go anywhere at all, because there were no designated areas and the government started trying to close them down. They are still fighting in court, and the one I spoke to has two full-time lawyers on the payroll to handle it.

Oh, and by the way, the nation’s biggest industry – shipping – pays no tax.

So let’s face it, there’s a long way to go. Greece’s problems run very deep – in fact they go back to it being part of the Ottoman empire for 500 years and then when it got independence in 1830 it turned to Germany for a King (Otto). And then when there were elections, the three political parties were called the English, French and Russian parties. And then in 1967 there was a military coup and a right-wing junta ran the country for seven years, which led to the rise of the radical left in the 1970s and ‘80s in reaction to it. The result is that Greece’s government institutions are weak and its politics is febrile.

While it’s definitely a tremendous turnaround opportunity, it’s definitely not short term and it’s not without some risk. There is much to do.

Last Week

By Shane Oliver, AMP

Investment markets and key developments over the past week

Shares had a good week helped by reasonable economic data, better than feared US earnings, some slightly better news on Greece and further monetary easing in China. While gold and metal prices fell, oil and iron ore prices rose with the latter helped by news that BHP will slow its iron ore expansion. Bond yields generally rose, except in peripheral eurozone countries where yields fell. The Australian dollar ended little changed.

The tech heavy Nasdaq finally reached a record high but it took 15 years to surpass its tech boom peak, highlighting the importance of starting point valuations in driving long term returns. And for those worried about a return to the tech bubble, the price earnings multiple on Nasdaq at around 30 times is a fraction of the 190 times seen at the March 2000 tech boom peak levels.

Chinese shares continue to excel despite soft data and tougher margin restrictions. A move by the Chinese security regulator to tighten restrictions around leveraged share trading via trusts and allowing more short-selling had many worried about the Chinese share market a week ago. Continuing soft data are also a drag. However, it’s clear that the regulator is trying to promote a healthy share market and not trying to derail it. More importantly any negative effect was more than offset by an aggressive move by the PBOC to cut bank required reserve ratios. With the reserve ratio remaining high historically and monetary conditions remaining too tight several more reserve ratio and benchmark interest rate cuts are likely. Expect the later to fall to 4 per cent from 5.35 per cent currently. For Chinese shares we continue to see more upside, albeit a correction would be healthy. Chinese H shares remain very cheap, Chinese mainland shares remain cheap historically and Chinese institutional funds have relatively low exposures to shares and are likely to want to boost them which could ensure that any correction will be shallow.

The Greek mess is dragging on but is still unlikely to drive a return to the eurozone crisis. While there were some signs of progress over the last week, agreement on a funding release looks like it will drag into May and possibly June. Meanwhile, the risk of a “Graccident” (Greece defaulting on either debt or social security payments) sometime in May is clearly on the rise. This will not mean that a “Grexit” (Greek exit from the euro) will be inevitable and in fact it could help focus the mind of the inexperienced and unstable Greek Government on the tenuous situation they are in forcing them into an agreement. But it could result in a bit of market volatility. The good news is that the rest of Europe remains far stronger than it was a few years ago with significant budget repair and economic reforms in peripheral countries and the ECB's quantitative easing program. So a Graccident or even a Grexit is unlikely to derail the eurozone economic recovery, but news around Greece has the potential to cause a few bumps in the months ahead.

More RBA easing is likely on the way but uncertainty remains around the timing. The message from the minutes from the RBA's last meeting were if anything a little more dovish, particularly in regards to the weaker outlook for business investment and exports. A speech by Governor Glenn Steven's was clearly dovish highlighting that the question of another rate cut has to be on the table, that the $A remains too strong and that commentary on house prices remains too focussed on Sydney. Meanwhile, March quarter inflation data was clearly benign and leaves plenty of scope for the RBA to cut again, but it was not low enough to make a cut in May a slam dunk. We think another cut is justified on the back of the weak investment outlook, the greater than expected fall in commodity prices and the upside risks to the $A at a time when it remains too high, but a May move is a very close call.

Major global economic events and implications

US economic data was mixed again. Data for existing home sales and home prices rose more than expected, weekly mortgage applications are starting to trend up again and jobless claims remained about as low as they ever get. However, new home sales fell more than expected in March and the Markit manufacturing conditions PMI surprisingly fell, although it remains at a relatively solid level.

Meanwhile, first quarter earnings results in the US are not proving to be quite as weak as feared. Of the 189 S&P 500 companies to have reported to date, 76 per cent have beaten earnings expectations, 51 per cent have beaten on revenue and earnings growth expectations for the quarter have improved from -5.6 per cent year on year a month ago to now being -2.4 per cent year on year. The strong $US is still having a negative impact though, a point which is not being lost on the Fed.

Eurozone business conditions PMIs and consumer confidence unexpectedly fell in April. However, this needs to be seen in context as it followed several months of good gains since last year and the PMIs remain at levels consistent with improved economic growth. So there is no reason to get too concerned.

Japanese data was mixed with a weak leading index for February and another fall in its manufacturing conditions PMI in April, but a much better than expected trade surplus and stronger tertiary sector conditions.

The HSBC China flash PMI was softer than expected in April. It remains in the same 48-52 range it’s been in for the last four years, but nevertheless supports the case for more policy easing in China.

Australian economic events and implications

March quarter inflation was low at 1.3 per cent year on year and 2.4 per cent year on year for underlying inflation. Interestingly, "government affected" areas like health, education and alcohol and tobacco continue to see solid increases but areas indicative of private demand like clothing and household equipment remain weak reflective of soft underlying economic conditions. Meanwhile, skilled job vacancies rose modestly in March and are up 7.7 per cent year on year but are down 5.6 per cent year on year in Western Australia as the two speed economy continues to go in reverse.

Next Week

By Craig James, CommSec

Few highlights in Australia

There are few stand-out economic events scheduled in Australia in the coming week. The main event is a speech by the Reserve Bank Governor on Tuesday while data on home prices and some inflation indicators are released.

Reserve Bank Governor Glenn Stevens will deliver a speech at the Australian Financial Review Banking & Wealth Summit, in Sydney at 8.40am on Tuesday. With inflation data well and truly in the can, he will be in a position to drop hints about interest rates, should he so desire. Arguably this would be preferable rather than using targeted journalists to deliver the message.

Also on Tuesday, the ANZ/Roy Morgan weekly survey of consumer confidence is issued. Confidence stands at an 8-month low.

On Thursday, the Australian Bureau of Statistics will issue data on export and import prices for the March quarter. On the same day the Reserve Bank releases the “Financial Aggregates” report for March, which includes money supply measures and private sector credit (loans outstanding). We expect that credit rose by around 0.5 per cent in March to be up just over 6 per cent over the year.

And on Friday, the ABS releases the producer price indexes – key measures of business inflation. It will be important to see whether the lower Aussie dollar is causing prices of imported goods to lift across the docks.

Also on Friday the ABS releases delayed data on tourist arrivals and departures while CoreLogic RP Data issues latest home price data and the AiGroup issues the Performance of Manufacturing index.

Big week for overseas economic events

While there is a tame schedule of domestic economic events in the coming week, the same can’t be said for the US. Not only does the Federal Reserve policymaking committee meet but ‘top shelf’ economic data will be issued.

The week begins on Monday when the Markit organisation releases a “flash” (or early-warning) gauge for the services sector. The Dallas Federal Reserve releases a business index on the manufacturing sector.

Over Tuesday and Wednesday, the Federal Reserve Open Market Committee meets to decide monetary policy settings. The guessing game on when the Fed will lift rates won’t be resolved. However the text of the decision will be important in determining whether the Fed is on course to lift rates mid-year or whether it is likely to be delayed.

Also on Tuesday data on consumer confidence is released together with the CaseShiller measure of home prices, influential Richmond Federal Reserve index and weekly chain store sales data. Annual growth of home prices may have edged up to 4.7 per cent while consumer confidence may also have lifted modestly.

On Wednesday, the first reading (“advance” measure) of economic growth in the March quarter will be issued. Economists expect that gross domestic product (GDP) grew at an annualised rate of just 1.1 per cent in the March quarter, down from 2.2 per cent in the December quarter. But rather than signalling a slowdown, the data highlights the influence of harsh winter weather in constraining growth in the economy. The pending home sales index is also issued on Wednesday.

On Thursday, data on personal income and consumption (spending) are released in the US as well as the employment cost index, Chicago purchasing managers index and the usual weekly data on claims for unemployment insurance. Income is tipped to lift 0.2 per cent with spending up 0.4 per cent. And the employment cost index will be important in guiding views about when the Federal Reserve will start lifting rates. No wage pressure – no rush to lift rates.

And on Friday in the US the ISM manufacturing gauge is released together with construction spending, new vehicle sales and consumer sentiment.

Meanwhile in China, the National Bureau of Statistics will issue both the manufacturing and services purchasing managers indexes for April – key gauges of economic activity in the world’s second largest economy.

Sharemarket, interest rates, currencies & commodities

The US earnings season hits top gear in the coming week. And it’s a case of so far so good with Thomson Reuters estimating that nearly 76 per cent of S&P 500 companies have reported earnings above analyst expectations, topping the 70 percent average in the last four quarters.

On Monday, nine stocks from the S&P 500 index are expected to report including Apple. On Tuesday there are another 37 companies listed to report including Ford, Kraft, Merck, Pfizer and United Parcel Service.

On Wednesday earnings results are expected from another 37 companies including Goodyear, MasterCard, and Time Warner.

On Thursday 46 companies should issue profit results including Automatic Data Processing, Exxon Mobil, and ConocoPhillips.

And on Friday there are 10 companies listed including Chevron and Moody’s.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free