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July has been kind to Spain and Italy, with the respective equity markets rising about 8.5% and 7.5%. The benchmark 10-year yields have fallen 10 bp and 15 bp, while the two-year yields have tumbled 30 bp and 32 bp, respectively. The economic data suggests both countries are slowly recovering. Nevertheless, it is cause for concern and, whether it is the end of the summer holidays or the German election in late September, Q4 may be more challenging for both countries.

Earlier today, Spain reported Q2 GDP. The 0.1% contraction was in line with expectations. It was the eighth consecutive quarterly decline, though the least since Q3 2011. The economy is about 7% smaller than it was five and a half years ago. The manufacturing PMI stopped contracting in June, and the July report (for release on Aug. 1) is expected to move into positive territory (above the 50 boom/bust level), though the service PMI is expected to still be contracting. The labor market appears to have stabilized, but some of the improvement appears seasonal in nature, related to tourism.

One of our perennial concerns about Spain relates to housing prices, which, despite a roughly 30% decline from their peak, still have not bottomed. Spain recently reported that house prices fell 2.4% (not seasonally adjusted) in Q2, to begin the sixth year of decline. Prices are about 7.5% below a year ago. The fall in house prices in Spain compares to a peak-to-trough decline in the U.S. of about 32% and about 20% in the U.K. However, we continue to suspect that the 50% decline that Ireland experienced is more likely Spain's path.

The Bank of Spain seems to be sympathetic with this assessment and cautions that in terms of average household income, an additional 18% decline in house prices is necessary to bring the ratio back to historical average. Moreover, household income is not constant and there is additional pressure on wages to continue to decline. Meanwhile, Spanish banks are under increasing pressure to cut dividends. Banco Santander (NYSE:SAN), Spain's largest bank, reported earnings today and the country's second largest bank, Banco Bilbao Vizcaya Argentaria SA (NYSE:BBVA), reports tomorrow. Santander's Q2 profits rose eightfold. Bad loans, however, rose to 5.18% from 4.76% in March as the central bank forced some reclassification of loans to "doubtful." Net loan loss provisions fell to 3.07 billion euros from 3.4 billion a year ago.

Santander claimed that its capital position means that it will be able to maintain its 0.6 euro a share dividend. The IMF and the Bank of Spain want Spanish banks to reduce their payout and limit cash dividend to 25% of profits. The bulk of Santander's dividend is paid in new equity, but the BoS is also concerned about the overall dividend payout. BBVA paid out 37% of its profits last year and Banco Sabadell (OTC:BNDSF) paid out closer to 50%.

Italy's economy appears to be lagging behind Spain's. The manufacturing PMI is still contracting, even if at a slower pace. It preliminary release of Q2 GDP is due out Aug. 8 and the economy most likely contracted for the eighth consecutive quarter. After contracting 0.9% in Q4 12 and 0.6% in Q1, a 0.4% contraction is thought likely in Q2. The Italian economy is roughly 7% smaller than in 2007. Italy's central bank is looking closer at the books of eight (unspecified) banks as a follow up to last year's examination of 20 banks. The Bank of Italy is urging banks to boost capital, curb operating costs, dividends and executive/directors' pay and sell non-strategic assets. At the end of last year, the central bank required banks to boost provisions after the coverage ratios had declined. According to the central bank, Italian banks have provisions for 43.5% of their non-performing loans at the end of 2012, up from 31% at the end of Q3 2012.

Separately, Brussels is insisting that Monte dei Paschi adopted stricter measures on executive pay, cost cutting and treatment of some creditors, before it approves a 3.9 billion euro state bailout. The bank continues to pay a discretionary coupon payment to some key bond holders. Such coupons usually have be terminated as a condition for receiving tax payers' money. Some estimates warn that if Brussels demands are fully implemented, it could cost as many as 5,000 jobs. The center-left is reportedly closely tied to the bank and such an outcome could renew tensions in the fragmented center-left coalition.

The more immediate threat comes from the center-right. Today the Supreme Court is to hear Berlusconi's final appeal on tax fraud charges. It is not clear whether a ruling will be handed down today or tomorrow. If Berlusconi's conviction is upheld, which seems most likely, there is fear that the ministers from the PDL (center-right) could resign and thereby potentially topple the government. It is possible that they resign and still support the government on a case-by-case basis, but such a scenario does not look sustainable for long. Indeed, it might not last through the fall debate over the 2014 budget.

Separately, Berlusconi is appealing another conviction (for abuse of office and paying for sex with an underage prostitute). He appears to be gradually planning for his succession. Local press reports indicate that Berlusconi will re-launch his Forza Italia movement in September, and will seek to appeal to the youth and business leaders. His eldest child, Marina Berlusconi, already heads up the family's media business and publishing group, and there is speculation that she is the heir apparent to her father's political base as well. In a foretaste of things to come, Marina is seen as a likely rival to the up-and-coming star in the center-left, Florence Mayor Matteo Bersani, perhaps in an election in 2014.

Source: Spain And Italy Update