Seeking Alpha
Small-cap, macro, value, momentum
Profile| Send Message|
( followers)  

Just when many thought out loud (or perhaps a better expression should be 'hoped') that the multi-headed euro crisis was receding on the back of the ECB finally backstopping, the Greek 'bond swap,' and a rather dramatic rise in the quality of Italian governance, it raises (one of) its ugly heads again in the form of Spain.

This is really bad news we can do without. Some Spanish data will show that the picture isn't particularly appealing:

  • Unemployment is around 23% (the highest in the EU) with youth unemployment particularly high at 50%(!)

  • But a combination of austerity, economic crisis, and new labor laws are likely to worsen this picture considerably. "Many Spanish companies had been holding off from shedding workers until the labor reforms were passed last month," according to Moneymax

  • On Friday, PM Rajoy presented a budget with a 27B euro austerity package. This comes on top of a 15B euro package presented three months ago

  • Despite (or some would even argue because of) all that austerity, Spain has missed its budget targets. The public deficit is supposed to be reduced to 4.4% of GDP in 2012, but Rajoy has upset Brussels (and, more ominously, Berlin) that he thinks this is way too ambitious and is aiming for a deficit of 5.8% instead (although lowered to 5.3% after considerable pressure from eurozone authorities), even if the target is still 3% next year.

  • But even 27B euro cuts fall short of the 34B euro cuts that are needed to reduce the deficit to that 5.3% target

  • Outstanding public debt, while rising fast, is still relatively moderate at 68.5% (lower than Germany's 81%, for instance). However, some argue including all possible liabilities, it's a lot higher, at 133.8% of GDP. Although we think that's a pretty stark exaggeration (many of the liabilities would only manifest themselves if the whole Euro area implodes), Willem Buiter from Citigroup thinks it could rise as high as 90% when all the various categories of debt are added together.

  • Fact is that Spain has a very high private sector debt, as a result of the housing bubble. And weak banks as a result.

Simply ponder the following awful figure:

Citigroup expects the Spanish economy to contract by 2.7% this year, where the Spanish government bases its figures on a 1.5% decline.

The bond markets
After a quiet period following the three year loans to the banking system from the ECB and the latter not having to intervene in Spanish or Italian bond markets for quite some time, yields are etching up again but they are still quite well behaved. But this is due to the ECB three year liquidity injection (LTRO) into the banking system, as Spanish banks are the main buyers of newly issued Spanish sovereign debt, according to Citibank's Willem Buiter. But we also know bond markets can turn rapidly.

Austerity vicious cycle?
Could Spain fall into a similar self-defeating austerity cycle where austerity leads to negative growth and tax receipts, needing more austerity and ratcheting up the debt/GDP ratio like in Greece? It's early days, but the dynamics of missed targets, negative growth, and fast rising debt/GDP ratio is already in place. If even ZeroHedge comes to the conclusion that austerity doesn't work, what is the world coming to! Only the Bundesbank and Cameron's Chancellor of the Exchequer George Osborne remain as the last vestiges of this doctrine. Here is the UK Telegraph:

Fresh data from Spain's treasury showed the deficit for January and February was worse than for the same period last year, even stripping out "one-off" costs stemming from excesses by the regional juntas. The lack of progress is grist to the mill of critics who argue that drastic "pro-cyclical" cuts can prove self-defeating, as Greece has discovered.

Then again, what's the alternative? They can't reflate by monetary means, they can't devalue, it would be helpful if the eurozone center would reflate, to shift at least some of the burden of adjustment to the surplus countries, but that isn't going to happen any time soon, or ever.

Even though ZeroHedge (or, more precise, Peter Tchir) claims that spending is what got these countries into trouble, this certainly isn't the case for Spain, which had a budget surplus and one of the lowest debt/GDP ratios in the developed world on the eve of the financial crisis.

To make matters worse, cuts will be on those items that are most beneficial to improving the supply side, like education and infrastructure, while maintaining consumption (pensions remain indexed, for instance and there is no rise in VAT).

In a deeply depressed economy these would be some of the first things that come to mind for spending public money on as they not only employ people and boost demand in the short run, but they also increase the productive capacity of the economy in the longer term.

There was some talk in Europe about having a 'growth strategy.' Watching Greece spiral downwards, a realization has started to sink in that austerity alone can very well be self-defeating. Any growth strategy would likely involve at least a considerable amount of infrastructure spending, and education is also known to produce significant returns longer-term. So austerity still rules, is the conclusion.

Exposure to Portugal
Contrary to what many argue, Spain hasn't gotten into trouble because of any fiscal profligacy. In fact, on the eve of the financial crisis it ran a budget surplus and had very low public debt outstanding. No, the Spanish disaster was caused by massive private sector gorging on cheap credit, much of it coming from abroad, creating a rather epic housing bubble.

Spanish banks are still weak and any downturn in the economy and further falling house prices or tumbling project developers will weaken them further. But they also have exposure to another country in deep trouble, Portugal. Its economy is expected to shrink a whopping 3.3% this year and while Portugal's public finances are in a much bigger mess than Spain, it's private sector is also quite heavily indebted:

much of the borrowing by Portuguese companies has been financed by Spanish banks. That creates the possibility of a domino effect, whereby a financial squeeze in Portugal leads to a crunch in the Spanish banking sector. [Time]

Spanish banks and the housing market
According to Buiter, the Spanish banks are the main buyers of newly issued Spanish sovereign debt. No doubt the ECB's 3 year (LTRO) loans have something to do with that. Indeed, here is the Telegraph:

Spanish lenders have increased their dependence on loans from the European Central Bank to a record €152bn, using the money to roll over debts or buy Spanish government bonds - concentrating risk further.

But with the economy in full retreat and house prices still falling and many people getting evicted, things look bleak, according to Buiter:

The decline in Spanish land and property prices appears far from complete (probably less than half complete). The General IMIE Index, an indicator created by Tinsa, increased its year-on-year decline in February, and fell by 9.5% - returning to the levels of 2004. The cumulative decline in the General IMIE Index from the top of the market in December 2007 was 27.1%. In addition to the hidden legacy losses carried by the Spanish banks, new property- and real estate-related losses are likely to come their way as a result of further property price declines. The Spanish banks are unlikely to be able to absorb these losses. If these institutions are deemed too important to fail, these losses could migrate to the public sector, which could have severe problems carrying them.

Which is likely why the European Commission has suggested to Spain to tap the EU's bailout fund to help restructure the banking system to avoid a serious credit crunch [El Pais, quoted in The Telegraph]

Political problems
It remains to be seen, with strikes in Spain, strikes in Italy, and strike in Portugal, if the tolerance for more of the same might wane, although the lack of a clear alternative (nobody is suggesting Spain would be better of leaving the euro) might keep a lid on that.

Some trading suggestions
Should the euro crisis flare up then obviously the euro itself is on the first firing line. One could short those that are long on the euro, like CurrencyShares Euro Trust (FXE), WisdomTree Dreyfus Euro (EU), iPath EUR/USD Exchange Rate ETN (ERO), or be bold and short leveraged long euro ETFs like: Ultra Euro ProShares (ULE), or Market Vectors Double Long Euro ETN (URR). Or invest in short euro ETFs like Market Vectors Double Short Euro ETN (DRR) or UltraShort Euro ProShares (EUO).

The Spanish stock market, as well as the Italian (contagion fear - even Mario Monti, the Italian PM, is worried about that) will do badly. The two country ETFs are iShares Spain ETF (EWP) and iShares Italy ETF (EWI). Unfortunately, the Spanish ETF (as well as the Italian one) is geared towards big international companies. They will suffer too, but not to the extent of purely domestic companies, which will suffer just from the depressed economy alone, let alone any euro crisis flare.

The Spanish ETF has the following as top ten holdings:

  • Telefonica SA (TEF): 20.73%
  • Banco Santander SA (SAN): 19.43%
  • Banco Bilbao Vizcaya Argentaria SA (BBVA): 11.29%
  • Industria de Diseño Textil,S.A."inditex" (OTCPK:IDEXF): 5.04%
  • Repsol YPF SA (OTCPK:REPYF): 4.88%
  • Iberdrola SA (OTCPK:IBDRY): 4.47%
  • Abertis Infraestructuras SA (OTCPK:ABRTY): 2.80%
  • Gas Natural Sdg, S.A. (OTCPK:GASNY): 2.50%
  • ACS Actividades de Construccion y Servicios SA (OTCPK:ACSAF): 2.23%
  • Red Electrica de España, S.A. (OTCPK:RDEIY): 2.17%

There is still a good deal of domestic exposure in there (especially the smaller holdings). Trading individual stocks will not get you very far.

Of course, some would argue that the Spanish stock exchange is currently very close to the bottom of March 2009 and half the value of the top late 2008. But things can always go lower still..

Source: Next Up: Spanish Bailout?