June 2015 – Monthly Commentary
The bond market was under selling pressure for most of June as the economic data released during the month was unequivocally positive. On the back of that, stock prices soared and interest rates drifted higher. Reacting to the upturn in economic activity, Fed Chair Yellen, at the post Open Market Committee meeting, said that the market should prepare for a rate hike before year end. Reflecting that comment, the FOMC’s year end forecast for Fed Funds, also known as the “dot plot,” indicated two rate hikes by year end. Despite clearly bearish fundamentals, the selling pressure reversed with two trading sessions left in the month when Greek Prime Minister Tsipras broke off talks with European creditors. On the evening of the last Friday of the month, Tsipras did the unthinkable and announced that Greece would hold a July 5th referendum on austerity. Because that vote would occur after the June 30th IMF debt maturity, the penniless country would be forced to default on its debt. Initial market reaction was as expected with bonds up and stocks down. The first opportunity to trade came on Sunday evening as the Japanese trading day began. Bond futures opened two points higher, and then rallied by another 2 points over the course of the first 20 minutes of trading.
While Greece represents a very small percentage of the European monetary union, investors are fearful that a default would have a contagion effect and kill the nascent economic recovery in the bloc. Understanding that countries in the north want to avoid that, the Greeks seem to be willing to use that fear as a bargaining tool. We deem that strategy to be a risky one. Presently, the Greek economy is being supported by the Emergency Lending Authority from the European Central Bank (ECB). If the ECB terminates that emergency lending, economic destruction would likely ensue as the Greek financial system collapsed and its economy grinds to a halt. If that were to happen, the Greeks would likely be shut out of the capital markets and be forced to reestablish the Drachma as a currency. While reintroducing the Drachma would provide the economy with needed liquidity, the value of the currency would likely plunge unleashing a destruction of savings, a sharp increase in the Euro-denominated debt burden, currency controls and a sharp spike in inflation. The only bright spot in the Pandora’s Box of currency devaluation is a newly introduced and devalued Drachma would likely make Greek exports competitively attractive.
Also weighing on the fears of investors is the potential for Puerto Rico to default on their debt. While Greece stole the headlines at month end, investors held their breath that the island nation would make June 30th and July 1st debt payments. Governor Padilla last year assured investors and citizens that the fiscal situation could be managed and that default was not an option. At the end of last month, he reversed that optimism saying that the debt is “unpayable,” and that bondholders should share the pain being suffered by Puerto Rican citizens. Just as is the case in Greece, years of fiscally irresponsibility and excessive borrowing have left the country on the brink of default. And, as is the case with Greece, debt restructuring is a distinct possibility.
In addition to angst emanating from the Mediterranean and the Caribbean, the Chinese stock market became a cause for concern last month as the ferocious rally seen this year reversed course. Much has been written about the explosion of new retail trading accounts being opened this year as the Chinese considered the local stock markets as offering easy money. When it peaked last month, the Shenzhen A share index had a year to date total return of more than 125%. When the Chinese government attempted to deflate the mania last month by raising margin requirements, they unintentionally popped the bubble. Since then, the index has fallen by 38% in the last three weeks and at the time of this writing; the government has halted trading on more than 600 companies, and has banned many institutional accounts from selling. Many are speculating that the losses are responsible for the price drop in Crude Oil, Gold, and precious metals, as holders of those commodities are forced to sell to meet stock-related margin calls. The episode is yet another example of the unintended consequences of government intervention into the capital markets.