Global Markets Feel the Pain in Spain

Global Markets Feel the Pain in Spain June 8, 2010, Bill Witherell, Chief Global Economist

The euro dropped another 2.5% last week against the US dollar, reaching a four-year low against the greenback. Global equities ended a turbulent week by tumbling Friday, June 4, by -3.4% for the S&P 500 and -3.1% for the EuroStoxx 50. On Monday, markets continued to retreat, with the S&P 500 down another -1.35% and the EuroStoxx 50 off by -0.9%.  While there have been plenty of risk events affecting global markets, the Eurozone appears to have been at the center of investors’ concerns. Within the zone, Spain held center stage for most of the week, following a credit rating downgrade by Fitch. The European financial contagion that started in Greece was clearly aggravating Spain’s problems last week and now is affecting the bond markets of the “core” Eurozone countries, in particular, France.  In this note we focus on the situation in Spain and some implications for investors.

When the crisis in Greece first erupted, we emphasized the differences between Spain (along with Portugal) and Greece.  In contrast to Greece’s tiny economy, Spain’s economy is the fourth largest in the Eurozone.  In 2009, while Greece’s national debt was 115.1% of GDP, Spain’s was 53.2%.  Unlike Greece, Spain is a nation of savers and the savings rate has recently increased to 19%. Spain’s economic and financial policies have on the whole been more responsible. Those differences are still valid, but when financial contagion gains momentum, such fundamental distinctions can be swept aside.

Spain does, of course, have some serious homegrown problems.  The bubble in its housing and construction markets was probably the worst in Europe, and the aftermath of its bursting has hit the Spanish banking system.  Spain is justifiably proud of its bank regulatory system. The rules for the provisioning against bad loans are among the world’s strictest, with the result that the system is robust, despite the recently heightened pressures on it.  The weak part of the financial system is not the major banks; it is the 45 cajas de ahorros, unlisted regional savings banks, which are being pressured to merge, rationalize their bloated costs, and improve their capital structure. This process finally got underway in earnest after the central bank took over a struggling caja several weeks ago. There is a deadline of June 30th for state aid to help finance the mergers. In the meantime the weaker cajas have to rely on the European Central Bank, as money markets are essentially closed to them. While liquidity needs do need to be met, insolvency problems should be addressed by dealing with bad debts directly and injecting additional capital.

The spread of 1.8 percentage points between the yield on Spanish 10-year paper and that on German 10-year paper reflects investor concerns about the ability of Spain to meet its obligations. The Spanish government of Jose Luis Rodriguez Zapatero managed by just one vote to pass an $18.4 billion package of spending cuts. The government does not have a parliamentary majority, so any initiative requires seeking support from smaller parties. The resistance to measures such as a 5% cut in civil service pay is understandably great.

With an unemployment rate at 19.7%, as compared with the Eurozone average of 10.1, the situation is particularly adverse for making progress on liberalizing the labor market, but such reforms are essential for the future health of the Spanish economy. Over the 2000-2008 period, Spain and Italy were the only two EU countries to register declines in productivity. The government has drafted a law that would phase out the current system, which makes it onerously expensive to fire most workers. Labor unions are fiercely opposing such reforms and the outcome is uncertain.  The government’s efforts to reduce the budget deficit are frustrated by the near impossibility of reducing the number of government employees, other than by not replacing those that retire.

The pledge of Mr. Zapatero to reduce the budget deficit to 3% of GDP by 2013, in line with Eurozone rules, will be difficult to achieve. The fiscal tightening that implies suggests further years of painful underperformance by the Spanish economy. The longer needed labor reforms are deferred, the greater will be the cost. We do anticipate, however, that Spain will be able to meet its financial obligations. Unlike Greece, Spain is not likely to require a rescheduling of its debt.

The prospect of several more years, at least, of an underperforming economy implies an underperforming equity market as well.  The MSCI Spain equity index is down -38.45% year-to-date, more than double the -17.53% decline in the MSCI Germany equity index. At Cumberland our portfolios do not contain positions in the iShares MSCI Spain ETF, EWP. Also, because of its size, sluggish-at-best growth in the Spanish economy is a negative for the exports of other Eurozone economies, particularly its immediate neighbors, France and Portugal.

We do not know when the Eurozone debt crisis will ease. Governments have adopted stringent austerity programs but the market questions the implementation.  The European finance ministers have reached an agreement that calls for examination of draft budgets by the EU and other member countries each spring, which could bring improved cooperation and budget discipline, if the agreement is implemented. The ministers also formally initiated the European Financial Stability Facility, a special purpose facility that will sell bonds backed by guarantees from all the Eurozone countries and then lend to countries requesting assistance with their financing. The markets so far do not appear to be impressed and spreads continue to widen. We will be watching closely as Spain, along with Portugal and Italy, seek to sell their paper this week.

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