Let go

Human resources departments tend to prefer the "let you go" phrase to the harder 'you're fired', 'you're sacked' or "we're making you redundant" alternatives, all of which imply a rather one-sided discussion. "Let you go" could even, at a pinch, hint that it is in an employee's interests to leave.

We are now three years into economic recovery, and yet employment conditions still remain subdued in western economies. As we work through this deleveraging (debt reduction) phase, a lack of investment and sluggish consumer spending are restricting economic growth to a speed so slow it is dangerously close to stalling, and employment growth almost non-existent. As a result, cash interest rates are likely to stay low for the foreseeable future.

While bond yield curves are still steep (short-dated bond yields are much lower than long-dated yields), we believe there are rich pickings for investors who are willing to move 'up' the curve. Previously, the fear of inflation inhibited investors from reaping the benefits of these pickings. However, many non-western central banks - and even the European Central Bank (ECB) - have recently raised interest rates to choke off the threat of inflation, and they may have succeeded in their effort to dampen inflation expectations. The strategy of buying long-dated US bonds as a reaction to the Chinese rise in interest rates is a particularly interesting development. Searching the globe for markets that had priced in higher short-term interest rates was a positive strategy over the summer, and we feel there is further scope to do so. Elsewhere, there could be attractive opportunities in markets where authorities have begun to reverse interest rate rises; Turkey and Brazil are among countries to have done so already.

Meanwhile, we believe Europe remains the biggest risk to the global economy. The sovereign debt crisis remains unresolved and, if anything, we believe some aspects of it have worsened. While fiscal austerity is prevalent throughout the region, economic growth is not. As we return to that September 'back to school' feeling of fresh enthusiasm, we also start to realise that nothing has changed. So far, the authorities have tried to put off the inevitable, but as the economic numbers from the north of Europe start to deteriorate, there is a groaning realisation that events are reaching boiling point. The southern states are unable to reduce their deficits through fiscal austerity because their economies are not growing, as confirmed by recent data from Greece. There appear to be three solutions, none of which are appealing, remain:

This third option may have to be attempted. It would be a dangerous road to follow, and controlling any resultant contagion could be beyond the scope of the authorities. However, let's explore the possibility of letting Greece go.

We believe that, realistically, the current idea of a modest 'haircut' is not sufficient to bring Greece back onto a more sustainable budget path. A more drastic approach appears necessary, which would necessitate Greece leaving the euro. We have argued for some time that this is inevitable, and that all the other plans have simply been about building enough time for the European financial system to prepare for this eventuality. Unfortunately, time has now run out and we are not sure that the system is ready for a Greek default. A default with a 40% 'recovery rate' (return of capital) would reduce the Greek deficit to a more sustainable level. Introduction of a new drachma currency and support from the IMF would be essential, we believe, through what is likely to be a very difficult period. The hit to the Greek banking system and the economy would be huge, but would it be any worse than the present situation of depression and growing deficits? Current Greek bond prices almost reflect this scenario, so it should not come as a surprise.

Would the European banking system survive and would contagion be manageable? These questions are unanswerable at this stage but one could argue that, given the prevailing pricing of bonds, the markets have had time to prepare. We believe that the current plan of delay and fiscal austerity will not work and, as new bond issues build through September and October, events seem to be coming to a head. We think it is time to 'let go'.

In anticipation that Greece will default, we are significantly short in duration exposure to the periphery of Europe, and to the euro itself, despite ostensibly 'cheap' pricing, while acknowledging that one potential outcome of a break-up is a stronger euro....