Stock market rally built on perceptions

The continuing rally on the Athens stock exchange and the fast de-escalation of Greek bond yields were boosted by Fitch Ratings’ decision to upgrade Greece’s credit rating by one notch to B- last week and better fundamentals. However, more than that, the rally highlights the importance of perceptions in affecting market outcomes, according to some participants. If perceptions continue to improve, the country may move from a “bad” equilibrium of high interest rates to a “good” equilibrium of lower borrowing costs faster than economic fundamentals dictate.

Many Greek and foreign policymakers and others may be pleased about the country’s progress in cutting its twin fiscal and current account deficits and the partial implementation of structural reforms but are still quite reserved about its economic prospects, knowing there are execution and other risks ahead.

Their reservations are not unfounded. The economy is on its way to shrink by 4 percent or more in real terms for the sixth consecutive year, bringing the cumulative output loss to more than 20 percent over the same period, unemployment remains very high at 27 percent and living standards are continuing to decline.

Market participants, including investors and speculators, also read the same numbers and talk to all kinds of people around the globe, such as policymakers, but appear to have adopted a more positive stance toward Greek securities.

Mainstream institutional investors and banks from eurozone countries have yet to join in, according to people who claim to have some knowledge of the flows, but this is hardly surprising.

Greece is a high-risk country with a huge public debt in a bailout program. Even if some traditional European investors wanted to ignore recent high losses and dip a toe in the water, the risk management committees at banks and the charters of pension funds may have not allowed them. Greece is still rated deep in junk territory by the three major credit rating agencies even after Fitch upgraded the country’s credit rating to B- from CCC with a stable outlook, citing progress in cutting its public deficit and receding fears of a eurozone exit.

Readers are reminded S&P had upgraded Greece to B- with a stable outlook from selective default last December.

However, there are other investors who are less risk-averse and more willing to take on Greek risk at this stage. Hedge funds have a prominent place in this category.

By all accounts, some of them have taken positions in Greek bonds and stocks in the last few weeks and months, although local retail and private banking clients may have made a bigger contribution toward driving bank stocks through the roof since early April.

The bank stock index on the Athens bourse registered gains in excess of 68 percent last week alone. As a result, the implied market capitalization of the four core banks has jumped to extremely high levels after taking into account the new shares to be issued in the context of their recapitalization. However, history teaches that such high valuations are not sustainable for a long time.

Undoubtedly, the receding eurozone exit risk and the sharp drop in the general government budget deficit to 6.3 percent last year from 9.5 percent in 2011 have contributed to the change in investor sentiment toward Greek assets, mainly bonds.

At this point, it is worth mentioning that some assign greater importance to the compression of the current account deficit to less than 3 percent of GDP in 2012 and the continued improvement into this year as far as bond yields and spreads are concerned. According to this rationale, most of the Greek public debt is in foreign hands and therefore the key variable affecting the risk premium is the external account.

Nevertheless, some market participants argue that the rally in Greek assets has more to do with perceptions than anything else. According to them, the improvement in economic fundamentals has facilitated but not shaped the favorable change in perceptions. The global de-escalation of sovereign and corporate yields has also improved the market perception about risky assets, helping Greek bonds.

In addition, positive comments made by eurozone government officials and others have also played a role in changing investors’ perceptions about Greek assets for the better. German Chancellor Angela Merkel’s visit to Athens last October is considered to have constituted a key event in addressing concerns about Greece’s eurozone exit.

A more effective strategy in communicating economic data and focused comments by Prime Minister Antonis Samaras and senior Finance Ministry officials have also been a positive factor, especially compared to damaging comments made by their predecessors in the past.

Some academics and business economists argue that there are multiple equilibria in sovereign bonds markets and it would take just a change of heart by investors to move from one to another.

Assuming perceptions about Greek risk keep on improving in coming months, it is normal to expect bond yields and spreads will continue to decline. In this regard, Greece may move from the “bad” equilibrium of high interest rates and unsustainable debt to a “good” equilibrium of low rates, obtaining partial market access.