S&P To Hit 1200 Amid Euro Woes

Includes: FXE, SPY
by: Colin Lokey

In the ECB's latest attempt to deny the fact that despite two rounds of LTROs the situation in Europe is deteriorating at an astonishingly rapid pace, Governing Council Member Ewald Nowotny cheerfully rattled-off the following set of assertions on CNBC Monday:

On Spain: "For the time being, I don't see [Spain needing any help]."

On Europe: "I think the fundamentals ... are improving substantially."

On more LTROs: "For the time being our strategy is a steady hand strategy - let's see how it works."

Importantly, the IMF simply does not share the ECB's optimism regarding the situation as indicated by its actions and its words: the International Monetary Fund just completed an initiative which raised an additional $430 billion to help fight the crisis in Europe and warned the ECB that it needs to cut interest rates and inject capital into struggling eurozone banks or risk losing control of the situation.

The IMF of course, is referring specifically to Spanish banks whose total loans are now around 170% of GDP, a disturbing statistic for many reasons, not the least of which is that 8.2% of those loans are classified as "bad debt." For the purpose of providing some perspective, if U.S. banks were in the same situation, they would have 23.8 trillion in outstanding loans, 2 trillion of which would be non performing.

Mr. Nowotny's comments about Spain seem to largely miss the point. In the above cited interview, he mentions Spain's economy and fiscal reforms repeatedly even though no one is arguing that Spain's deficits are comparable to those of Greece--anyone who follows the crisis knows that it is the banks in Spain that are the root of the problem. If the banks aren't fixed however, they will be unable to buy more Spanish debt, an eventuality which could cause borrowing costs to rise further in the absence of foreign demand--yields on the 10-year Spanish note rose above 6% Monday, Spain CDS is still hovering at record highs above 500bps, Spain's stock market is down nearly 20% year-to-date and fell 3% Monday.

As for the rest of Europe, the fiscal union purposed by Merkel and Sarkozy is now in jeopardy thanks to the French elections in which polls show socialist challenger Francois Hollande defeating President Nicolas Sarkozy in a run-off vote on May 6. If Hollande wins, he has promised to fight against austerity measures, a position which could undermine global confidence in the eurozone's resolve to reduce deficits and institute broad fiscal responsibility. A loss of confidence in the eurozone's ability to battle the crisis with reforms could lead to higher borrowing costs and more downgrades--this is in fact already happening via a widening in the spread between EFSF bonds and German bunds (the spread is now at 3 month highs).

In an article I published on April 1, I said the following:

"the Netherlands (traditionally a country with a strong economy) is beginning to show signs of distress. The Dutch recently raised their deficit target for 2012 to 4.6% from 3% and the economy is expected to contract 1% during the year."

On Monday afternoon, the Dutch government collapsed amid a dispute regarding austerity measures. This could put the country in jeopardy of losing its AAA credit rating. The event caused the spread between Dutch government bonds and comparable German bunds to hit a 3-year high and Dutch CDS spiked to 2012 highs.

The events of the past week do not bode well for the market. European stocks closed down 3% Monday and U.S. stocks are down more than 1% as of this writing with all 30 Dow stocks in the red. As I have said many times this month, if things do not change in Europe soon, expect stocks to retrace to levels last seen in October when the eurozone crisis last flared-up. S&P target: 1200. Short SPY, long SPY puts, short Spanish banks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.