The Rain in Spain Will Bring More Pain

Includes: AEP, EWP, FPL-OLD, XLU
by: Bret Jensen

The market meandered back and forth for most of the day only to end up basically flat. This performance was actually more impressive than the final result, as the majority of news flow continued to be negative. The Fed may trim their growth estimates next week for the U.S. economy due to the debt crisis in Europe, May housing start numbers were putrid, Gary Shilling came out and projected stocks still have another 30% to fall and rumors that Spain needs a rescue package continue to be persistent even though stridently denied. On the bright side, the S&P ended slightly above its 200 day moving average.

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After the major oil firms threw BP (NYSE:BP) under the bus during congressional browbeating yesterday, the president followed up his oval office speech last night and finally met with BP executives 58 days after the massive spill in the gulf. He used his Chicago political gifts to raise/exhort 20 billion dollars for a political slush fund/escrow account to help businesses impacted by spill in the gulf, as well as workers affected by the administrations ill conceived and shortsighted moratorium on offshore drilling.

Although this funding mechanism has no legal precedent, the BP CEO and board chairman showed they were as hapless in handling this situation as they have been to this point in capping the well. This concession will eventually be the end of BP, as it is just a down payment on the eventual real and political cost of this disaster. It will not cover fines, lawsuits or other congressional claw backs. I will give the president his due; he is definitely the most prodigious of fundraisers. One day, the other oil majors may wish they had followed the founding fathers advice “We must hang together, or we will surely hang separately”.

It is becoming more obvious that Spain will likely be the next domino to fall in Europe. Given recent comments and developments in that country, it is only a matter of time before the government there will have to go hat in hand to IMF and EU for their bailout. This is hardly surprising given the revelations about Greece, but it is certain to have major ramifications for Europe, worldwide growth prospects and the markets. Greece was the first “cockroach”, and it looks now like Spain will be the next. Actually given Spain’s economy is approximately four times the size of Greece, maybe we should say it will be the next “Rat” to emerge from Europe’s sovereign debt debacle. Given this backdrop and the likely scenario that we will pull back to the 1100 line on the S&P prior to option expiration, I would be very selective here. If pullback ensues, I would look to pick up some selections in the Utilities Index as they have outperformed in recent weeks and provide a good yield at decent valuations. American Electric Power (NYSE:AEP), FPL Group (FPL-OLD), or XLU would be positions I would be comfortable taking in this environment.

10 Reasons why Spain is in deep trouble

1. The yield on newly issued 12 month bonds has gone from 70 bps to 230 bps in a month

2. Spain has a 20% unemployment rate

3. Debt was recently downgraded by Fitch, it will not be the last downgrade

4. New austerity measures were passed by one vote which will have a couple of ramifications

a. Further negative impacts to Spain’s growth rate

b. More strikes as the unions were out in the street prior to these measures even being passed

c. Increases possibility that government will not last to next planned elections in 2012, as 13 of the current ruling coalition members abstained on the austerity vote

5. The Cajas (saving banks) in Spain are in deep, deep trouble and are being pushed to merge quickly. Given they provide 50% of the business lending in Spain, and will probably require a large bailout at some point; this will be another significant negative for economic growth

6. Per capita, Spain has six times the unsold homes as does the United States

7. Spain admitted this week that its banks are in trouble and some European bank counterparties are reluctant to lend to them. Spanish banks borrowed a record from the ECB last month

8. The budget deficit was over 11% of GDP in 2009. Given high unemployment, accelerating economic contraction and the rising yields being demanded to finance Spain’s debt right now, the outlook for reducing that deficit number in 2010/2011 is growing more unlikely by the day

9. CDS rates on Spanish sovereign debt are at the same approximate range as Greek debt was about one month before they needed to be bailed out

10. Rumors are already circulating that the IMF and EU are working on a 250 billion euro bailout package. Although these rumors are being denied vociferously, where there is smoke there is fire

Spain is the fourth largest economy in Europe and 16th largest in the world. It also has over 1 trillion worth of external debt, most of it held by other European countries and banks. Obviously any bailout and/or default with have huge impacts to the prospects to European and worldwide growth as well as the potential to severely impact the debt markets worldwide. This is an unfolding event we must keep a close eye on and react accordingly. Stay small, stay defensive, and be careful out there.

Disclosure: Long AEP, FPL