JP Morgan: Dodging the Greek bullet

The week ahead should be a busy one for financial markets as policy makers react to the results…

The week ahead should be a busy one for financial markets as policy makers react to the results of the Greek election, the Federal Reserve considers further easing measures and investors ponder the pace of expansion in the U.S. and global economies.

First, markets should appreciate a positive result from the Greek election. Since the first inconclusive parliamentary election on May 6th, opinion polls had shown the Greek electorate aiming a gun at its own foot as the radical left-wing party Syriza had initially been favored to be the largest party in the parliament in a second election. If Syriza had prevailed there was a significant chance that it would have implemented policies that would have led to a default on Greek debt and an effective exit from the Euro.

In the event, the moderate right-wing New Democracy party garnered roughly 30% of the vote compared to 27% for Syriza and, by virtue of being the largest party, gets a 50-seat bonus in its representation in the Greek parliament. In addition, in contrast to the May 6th election, the New Democracy party and the moderate left-wing PASOK party should have the seats to form a relatively stable coalition government.

For Europe, this should be a relief as it avoids an immediate crisis. However, the strength of Syriza, along with the victory of the French socialists in Sunday’s parliamentary elections, is sending a powerful message that voters believe a diet of pure austerity is not working. The challenge for Europe’s leaders, which they will need to address at the European Council meeting on June 28th and 29th, is to be bold enough to embrace short-term stimulus to restart their economies, while laying out a path of long-term budget discipline to deal with their still-growing debt.

It is possible, but not probable, that they will get this right. A more likely outcome is insufficient stimulus that will keep financial panic at bay and avoid a deepening of the recession but leave the debt crisis festering in still-stalled economies.

This, should not, on its own, justify further Federal Reserve easing. However, there is a good chance that a super-dovish Fed will take further measures this week either in a second dose of Operation Twist, by further lengthening the maturities of its balance sheet or by emphasizing that it expects to hold the federal funds rate at current levels all the way into 2015. Neither measure could possibly help the U.S. economy. After all, there cannot be any American consumer or businessperson who is hesitating to borrow because interest rates are too high. More likely, such “aid” would further undermine confidence, thereby perversely acting as a drag on growth.

U.S. economic numbers this week should portray an economy that is neither strengthening nor faltering. Housing Starts on Tuesday could show a bounce, reflecting better weather and improvement in some other housing numbers. By contrast, Existing Home Sales, on Thursday may see a slight retreat after a good April. Unemployment Claims on Thursday are likely to remain at elevated reflecting some current sluggishness while the volatile Philadelphia Fed Index, also due out on Thursday, could bounce higher following a weak report a month ago.

Thursday will also see the release of “flash” purchasing managers’ indices for the U.S., Europe and China. These numbers are likely to confirm a slowdown in global growth. However, for investors, depressing global economic numbers, inappropriate fiscal policy in Europe and inappropriate monetary policy in the United States needs to be set against a continued extreme in valuations. Years of moving money to cash and fixed income has left many investors with portfolios which are too conservative for their long-term strategic goals while valuations suggest that all the opportunity is in the risky side of the asset class spectrum. For this reason, despite plenty to still worry about, long-term investors may still want to overweight equities and underweight fixed income relative to a “normal” portfolio.

David Kelly is the chief global strategist for JP Morgan Funds.