The primary reason for my bearishness regarding Europe is that accelerating economic contractions in PIIGS nations will cause them to violate fiscal targets that they have only recently agreed to. In fact, these commitments will be violated by a wide margin.
These incremental deficits have to be financed. As it is, Europe has not figured out how they will finance the deficits previously agreed to, much less new deficits. For countries such as Spain, Portugal and Italy, a showdown with Germany over the breech of commitments and the securing additional financing looms.
Spain To Miss Fiscal Targets By Wide Margin
In various articles I have said that the endgame in Europe will probably take the form of PIIGS economies shrinking more than expected, their revenues shrinking more than expected and fiscal deficits ballooning more than expected. All of this will cause fiscal targets and commitments to be violated on the part of PIIGS. This in turn will lead to a showdown with Germany centered on how such shortfalls will be handled.
Spain has now begun the process of acknowledging publicly that it will violate its commitments under recent accords; it is preparing the way for confrontation. According to various reports, Budget Minister Cristobol Montoro has warned that Spain will not meet its target deficit of 4.4% of GDP in 2012. Montoro said that this target was based on an outdated forecast of 2.3% economic growth for Spain in 2012 made by the previous government.
In my view, the absolute best-case scenario for Spain’s GDP growth in 2012 will be a contraction of -2.0%. My own base case estimate is for a contraction of -3.5%. A contraction that exceeds -5.0% is entirely plausible.
Even under the best-case assumption, Spain will miss its fiscal target by an extremely wide margin. A swing from +2.3% GDP growth to a contraction of -2.0% will necessarily bring about an enormous shortfall in fiscal revenue. Indeed, considering the economic contraction that it must endure in 2012, Spain will be lucky if it can keep its deficit below its 2011 level of -8.0%+. My own base case for Spain is for a deficit of about -9.0% of GDP. A much larger miss is entirely possible.
Who Will Finance The Additional Debt?
Extraordinary political and economic Pan European efforts were made during the second half of 2011 to cobble together a series of gut-wrenching agreements and compromises that would enable the financing of targeted fiscal deficits for the PIIGS in 2012 – in the case of Spain a deficit of -4.4% of GDP.
As it is, it has thus far been impossible for European nations to fund the EFSF financing mechanism that would ensure financings and roll-overs for Spain and other PIIGS in 2012.
Thus, the question arises: If it has been impossible to secure mechanisms that would ensure financing of a Spanish fiscal deficit of -4.4% of GDP, how is a fiscal deficit of -9.0% or more going to be financed?
Will the Germans support the expansion of the bailout facility? If so, will anybody finance this new and improved bailout facility? Will Germans approve the issuance of eurobonds in which they assume liability for PIIGS debts? Even if they do, will investors be willing to finance such bonds? Will the Germans allow the ECB to finance the Spanish shortfall through monetization, directly contravening the spirit of EU law? Even if they did, would the ECB, that has said many times that it will not do so, reverse itself and monetize this debt? Will European banks, that must deleverage, plug the financing gap by buying even more debt than they already have on their books? Why would anybody finance these PIIGS debts given that it is quite clear that these nations cannot grow with the euro as their currency and are therefore essentially insolvent?
After you have finished asking yourself these questions, ask yourselves these same exact same questions above with respect to Portugal, Greece, Ireland, Italy, and several other eurozone countries that will not meet their 2012 fiscal commitments.
Now, answer these inquiries for yourselves quickly, because very soon these questions will take center stage in diplomatic circles and financial markets. And when they do, stock and other asset prices will decline dramatically, because the answers to these queries are not at all reassuring.
The bottom line is this: The market has not yet come to terms with the fact that the PIIGS are in a midst of an economic contraction that will cause them to violate their recently agreed fiscal commitments by a wide margin. The size of the economic contraction in the PIIGS will be much greater than is currently forecast, and as a result, the size of the fiscal shortfalls will be enormously greater than currently forecast.
These fiscal shortfalls can only be financed through additional bailouts that must be directly and/or indirectly financed by the Germans – whether it be through financing mechanisms such as the EFSF or through the ECB. Worse still, for reasons I have discussed previously, PIIGS are fundamentally insolvent under the euro system and therefore the Germans have no realistic hope of ever being paid back.
Will the Germans go for it? Maybe, maybe not. What I am relatively certain about is that the Germans will offer up enormous resistance, at least at first. Thus, when the inevitable confrontation occurs and moment of decision arrives, global equity markets will be 20%-25% lower than they are presently.
I maintain my view that prior to late April of 2012, the S&P 500 will have initiated another leg down that will eventually take it to the 950-1,020 range. Notwithstanding the bullish configuration of the overall equity market, medium-term and long-term investors with cash should avoid the temptation of buying stocks and chasing them into this “bear trap.” Furthermore, investors should consider taking advantage of the recent rally to reduce their risk exposures to equities such as Apple (AAPL), McDonald's (MCD) General Electric (GE), Exxon (XOM) and ETFs such as SPY and QQQ.