GOLDMAN SACHS: 'It May Be Necessary To Take Greece To The Edge Of The Abyss'

Goldman Sachs in their latest note to clients on Greece writes that under the most likely of three scenarios for the political dynamic that arises in the eurozone after the June 17 elections in Greece, “it may be necessary [for the troika] to take Greece to the edge of the abyss.”

The Goldman team, led by the bank’s chief global equity strategist Peter Oppenheimer, points out that doing so “has been the strategy on past occasions: it may need to be repeated again, with the threat only being credible when chaos is imminent.”

The note goes on about the political posturing between Greece and the troika:

With each iteration of this game, the political cost to the two parties involved has increased. And to manage the domestic political pressures created by the arrangement, policy makers on both sides have adopted more outspoken language in their negotiations.

We have reached the stage where officials in the Euro area ex-Greece (not just the Germans and the Dutch) openly threaten Greece with expulsion from the Euro if the existing troika package is not adhered to by the new government, while leaders of rising Greek political parties openly say that the Greeks need not follow their bailout programme since the rest of the Euro area cannot throw them out given the costs involved.

Goldman details three scenarios that could occur following Greece’s scheduled June 17 elections and discusses each one’s impact on markets.

First Scenario: A Protracted 'Muddle Through' After June 17 Elections

In Goldman's 'most likely' scenario, which reflects current polling data, the new Greek government that arises from the June 17 elections will neither try to exit the euro nor agree to abide by the current troika bailout's requirements. In this case, the troika would probably halt all payments to Greece, showing them the 'edge of the abyss.' The ECB, on the other hand, would still continue to prop up Greek banks, keeping Greece in the euro for the time being.

Goldman writes that if this happens, 'we could finally see a political response on the Greek side: a government coalition prepared to agree to the troika terms could be cobbled together to avoid the descent into chaos.' Another, not mutually exclusive route in Goldman's eyes would be the introduction of a parallel currency in Greece, much like the 'Geuro' that was discussed recently by Deutsche Bank's Thomas Mayer.

Source: Goldman Sachs

A Muddle Through's Impact On Markets

Goldman writes, 'It is the threat of imminent danger that has tended to provide the forcing mechanism for policy makers in the past. For this reason there is a general belief that things need to get worse before they can get better.'

However, provided no hasty decisions are made and policy makers are able to act effectively, Goldman thinks that 10-year Bund and US Treasury yields should both rise above 2 per cent, 'with 'fair value' rising to around 2.5% on a 2013 horizon.' Peripheral bond yields should tighten, further narrowing the spread to Bunds.

Stocks should trade sideways in a muddle through situation. In the note, Goldman revises its three-month target on the Euro Stoxx 50 down to 2150 from 2350 (for reference, it closed Monday at 2147.92).

Source: Goldman Sachs

Second Scenario: Greece (Speed) Walks Away

Goldman sees Greece turning its back on the eurozone outright as unlikely in the wake of the June 17 elections, but the grim scenario the Goldman strategists lay out in the event that Greece does is interesting. They write of this scenario, which essentially amounts to a disorderly exit:

The threat of contagion to other peripheral economies and banking systems is serious. A full-blown bank run in Greece, extending to queues in the streets as panicked deposit holders seek to withdraw their savings, threatens to trigger disruptions elsewhere. Given the current pressures on parts of the Spanish banking system, this threat is particularly acute there. And Portugal -- a country also facing very substantial fundamental economic challenges -- would also be at risk, should it become apparent that the supposedly irrevocable commitments implied by monetary union have been broken.

From there, it depends on the policy response. If it's adequate, Goldman sees up to a 2 per cent reduction in Euro area GDP. However, if the policy response is not swift enough to keep up with the knock-on effects, in this case, the situation gets much, much worse. Goldman writes that 'an unravelling of the Euro area is possible -- with an associated fall in area-wide GDP that could approach double digits.'

Source: Goldman Sachs

Market Responses To A Rushed Exit

Goldman writes, 'Arguably, AAA-rated government bonds are discounting such catastrophic outcome to a greater extent than other asset classes, such as non-financial stocks and corporate credit.'

Even with this being the case, the strategists still think 10-year Treasury yields could trade down to 1.5 per cent and 10-year Bund yields to 1 per cent, and might even break through those levels for a short time.

Stocks would probably be very volatile and much lower as a result of a disorderly exit, according to Goldman. Oppenheimer's team points out that 'the sheer chaos of a euro unwind and the uncertainties over pricing contracts, and the extent of the counterparty impacts would not be obvious for some time; investors would probably assume the worst and ask questions later.'

Source: Goldman Sachs

Third Scenario: Greece Is Shown The Door

Goldman sees a third scenario as less likely than a muddle through but more likely than a disorderly exit: a managed exit from the euro initiated by the troika accompanied with a proper plan to stem its effects. The note admits that European leaders are nowhere near any such plan.

Further, the Goldman strategists think that if the rest of the eurozone decides to initiate the Greek exit, it will spook markets in other peripheral countries who now understand that such threats are very real. They write that 'therefore, the prompt introduction of effective and credible fire breaks, such as pan-European deposit guarantees to avoid bank runs by reassuring savers that their money will not be redenominated, will be crucial.'

If Europe could pull that off, Goldman says the drop in Euro area GDP could be less than 1 per cent.

Source: Goldman Sachs

How Markets Would React To The (As Yet Elusive) Deliberate Process

If Europe were able to come up with an actual plan to dismiss Greece from the eurozone in an orderly fashion, Goldman thinks the reaction in most markets would be favourable. Spreads on yields of peripheral government bonds in the eurozone would inherently be managed by an ECB commitment to intervene in those markets when necessary.

On equities, Goldman writes:

Above all, markets dislike uncertainty, and the clarity of a decisive move by the Euro zone on Greece could bolster confidence. If convincing firewalls and other policy supports were put in place the market could rally strongly from a lower level, as we saw following the LTRO.

Source: Goldman Sachs

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