11/11/2013 08:24 GMT | Updated 23/01/2014 18:56 GMT

What Is Driving the Greek Stock Market Recovery?

Amid the debt crisis and concomitant economic depression, the Athens Stock Exchange (ASE) lost 91% of its value between its peak in late October 2007 and its trough in early June 2012. Since then there has been a remarkable recovery in the ASE -- ahead of any significant economic recovery. As of early November, the ASE is at 245% of its trough value, but still only 22% of its peak value. But the stockmarket recovery since mid-2012 is still remarkable given that real GDP fell by 3.8% between the second quarter of 2012 and the second quarter of 2013. The stockmarket rebound has been driven by three key factors. First, the economy's future in the euro zone now looks more secure. Second, huge pent-up demand, given the sharp fall in GDP over the past six years, and lower labour costs boost the potential for profitability growth. Finally, the stockmarket's new "emerging market" status also entices some investors.

Euro exit risk diminished, but not gone

The first major factor supporting the stockmarket recovery is the decrease in the risk of Greece leaving the euro zone. Important in this regard were the second EU/IMF bail-out programme in March 2012, worth €130bn, which included the restructuring of Greek public debt held by the private sector, as well as the decision in November 2012 by the EU and IMF to provide significant debt relief to Greece. In return for Greece's progress on reducing its budget deficit and passing many agreed structural reforms, Greece's creditors have resumed concessional lending under the bail-out programme, thus reducing the risk of a disorderly default and subsequent euro exit.

Greece is on course to record a surplus on its primary budget balance (the balance excluding debt interest payments) in both 2013 and 2014. Economic growth is also set to return, although there is disagreement over the timing: the Economist Intelligence Unit expects full-year growth in 2015, in contrast to the government's expectation of growth in 2014 already. Many observers see the achievements of a return to economic growth and of a primary budget surplus as signs that Greece is now out of the woods, and believe that the chances of a euro exit are now miniscule (our assessment is a 30% risk). However, it is still possible that a future government takes decisions that derail reform progress, especially if there is a concomitant decline in EU/IMF willingness to continue to lend to the country, which could then ultimately still lead to a euro exit. This could happen if the political situation in Greece deteriorates significantly and an anti-bail-out party comes to power, such as the left-wing Syriza, following a snap election as early as next year--particularly in a climate of rising political violence, exemplified by recent violent attacks committed by and against the neo-fascist Golden Dawn party. A political crisis could seriously undermine and even reverse the recent stockmarket recovery.

Better prospects for profitability growth despite fragile economy

Greek real GDP is more than 25% below its pre-crisis peak in 2007. Hence, there is huge potential pent-up demand once the economy starts to recover. This entices investors as company profitability may recover quickly. However, the government's expectation of economic growth returning in 2014 is optimistic. Both hard and soft economic data still point to economic weakness in the short term. For example, the retail trade downturn decelerated in August, but the pace of contraction was still substantial (-7.8% year on year), and the European Commission's confidence indicator for the Greek retail trade sector dropped to a six-month low in October. With the unemployment rate at 27.6% in July (latest available data) and unlikely to fall dramatically in the short term, private consumption is set to remain weak in 2014 and recover much more slowly than exports. Net exports will continue to drive the stabilisation in economic activity and a return to growth in 2015, via a combination of still sharply falling imports and rising exports. However, expectations of sharp profitability growth by Greek companies in the short term are overoptimistic. There is a risk that Greece's stockmarket rebound has already priced in the expectation of an economic recovery.

Nonetheless, the potential for a recovery in profitability growth is not negligible. As a result of the EU/IMF-driven austerity agenda implemented by the Greek government, an "internal devaluation" in the country has reduced labour costs dramatically, thus lowering companies' cost base.

"Emerging market" status entices investors

In June equity index provider MSCI decided to downgrade the Greek stockmarket to "emerging market" status, as it was deemed no longer to meet developed-market standards for criteria such as size of market and lending facilities; the ASE had been classified as a developed market since 2001. The change will take effect after markets close on November 26th, and emerging-market funds that follow MSCI indexes will be allowed to invest in Greek equities after the downgrade has taken effect.

Within emerging markets, however, the Greek stockmarket looks quite powerful, especially now that other emerging markets such as India are in decline. Many investors in emerging markets see still cheap Greek company valuations as an opportunity. Greece now has many characteristics of an emerging market, such as huge (re-)growth potential, and its reform agenda to improve the business environment is set to continue, as long as the political outlook does not change dramatically. Unlike many emerging markets, its currency is strong and, for the time being at least, short-term exchange-rate risk is less of a problem than in many emerging markets, as long as concerns about Greece's future in the euro area do not re-emerge.