Evercore Pan Asset

As we feared earlier this week, markets had second thoughts about the Greek package. The combination of large sums being lent to Greece and continuing protests against the scale of cuts that the lenders insisted on was not a winning combination. The rioting, deaths of bankers and the wanton destruction of company and state property sent the wrong images flashing around the world on TV screens, undermining confidence in Greece still more.

Some worried that Portugal and Spain will need similar treatment to Greece. They are larger, and the sums could be too large for comfort. Others worried about the state of European banks. They have happily accepted Greek, Portuguese and Spanish government paper as part of their reserves and liquidity. The Greek bonds have cost them dear, falling value substantially. Could the Iberian bonds go the same way? What would that do to bank solvency and to the banks ability to lend more for recovery?

The European Central Bank tried to smooth the troubled waters by confirming that it will accept Greek government debt as collateral. They are trying to reassure markets that Greece will not default and so Greek debt is good quality Euro denominated sovereign debt. The ECB has not so far said it will buy any Greek debt in the secondary market. The markets were in no mood to be reassured, and worried more because the ECB takes this view. I don’t see how the ECB could do otherwise, as the EU is meant to supervise the budgets of EU member states. The EU loans to Greece were designed to say the EU as a whole accepted some responsibility for Greek finances.

There are now a couple of major fears stalking markets. The Greek tragedy is made worse by the inability of the Greek authorities to encourage a strong private sector led recovery to create jobs outside the public sector and to increase tax revenues from more activity. Could this spill over to other Euroland countries? The second is the state of the banks. Could the sovereign debt problems do yet more damage to the banks? Could there be a sequel to the sub-prime and CDO crises based on falling values of government debt?

We incline to the view that governments will seek to defend the weaker and smaller states, knowing that if they do not succeed in doing that the contagion will spread and there could be a major crisis. Meanwhile the Euro will weaken, making uncompetitive Euroland a bit less uncompetitive, which will help.

The UK election produced the split result as the polls predicted, confirming our view that it remains a country full of political risk. The Liberal Democrats’ success in the polls did not translate into large gains in terms of seats, but they and Labour together attracted more than half the vote and almost half the seats, implying a majority for delayed action in tackling the deficit if they manage to do a deal to govern together. We repeat Tuesday’s message – expect poor performance from Europe for a bit as they seek to sort out their government’ problems.