European Debt Crisis Never Went Away
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Spain May Become Greece, Only Much Bigger
2. Europe Can’t Kick the Can Much Further
3. Spain Could Send Global Equities Into a Tailspin
4. There Are Times to be Defensive
Spain May Become Greece, Only Much Bigger
US stocks are having a big day today, with the Dow up just over 200 points as this is written. But there are problems lurking in Europe that could be quite negative for global equities over the next several weeks. There are fears that Spain and perhaps Italy will need more bailout loans in the weeks just ahead. That’s our topic for today.
In December and January the European Central Bank (ECB) took the unprecedented step of loaning apprx. 1 trillion euros to European money center banks in an effort to buy some time for the banks to recapitalize. The loans had three year maturities, and the interest rate was an incredibly low 1%.
It is widely believed that the banks used most of the 1% ECB money to buy sovereign bonds of their own governments at much higher interest rates. Instant profit, crisis solved, some believed. By February of this year, interest rates on European government debt had retreated to “normal” levels. Most analysts predicted that the massive ECB loans would buy at least a year, if not longer, for the troubled countries which, in the meantime, would implement serious austerity measures to hopefully get their fiscal houses in order.
Yet over the last few weeks, the unexpected has happened – bond rates in countries like Spain and Italy have started to rise again to dangerously high levels. Ten-year Spanish bond yields climbed to the highest level since the ECB started allocating three-year loans in December. As you can see in the chart below, Spain’s 10-year bond yield soared to near 7% late last year, and many feel this is the reason the ECB finally implemented the €1 trillion of emergency loans.
Yields on Spanish bonds spiked last week and yesterday on news that Spain’s major banks increased borrowing from the ECB by almost 50% in March, reaching the most on record. The increase in Spanish yields caused rates to rise in other countries in the region. Italy’s 10-year rate rose above 5.5%. All of this is causing renewed fears that the financial crisis in the Eurozone is intensifying.
Making matters worse, Spain’s economy has moved back into recession. Finance minister Luis de Guindos confirmed that Spain has tipped back into recession, with a 0.3% GDP contraction in the 1Q. He expects the economy to shrink by 1.7% this year. Among others, Citigroup believes that the recession in Spain could be much worse. Overall unemployment is already 23.6% and for those under age 30, the rate is 50%. The Spanish stock market has plunged 30% over the last year and fell 3.6% last Friday alone.
To put what has happened over the last few months in perspective, let’s turn to a good (and understandable) analysis of the situation by Desmond Lachman, writing for RealClearMarkets.com last Thursday.
Europe Can't Kick the Can Much Farther
By Desmond Lachman
Evidently EUR 1 trillion does not buy very much in Europe anymore. Judging by the financial market's renewed unease about Italy and Spain over the past week it would seem that all that the European Central Bank's EUR 1 trillion liquidity injection in the European banking system bought was around four months of relative market calm.
In December 2011, in response to signs of acute funding problems for the European banking system, as well as in reaction to a marked increase in Italian and Spanish bond yields to unsustainable levels, the European Central Bank (ECB) embarked on a highly aggressive new round of quantitative easing. It did so by providing European banks, in two installments, unlimited amounts of three-year financing at a 1 percent interest rate through its Long-Term Refinancing Operation (LTRO). By February 2012, the European banks had availed themselves of this cheap ECB funding to the tune of a staggering EUR 1 trillion.
Yet, by early April 2012, Italian and Spanish bond yields were again rising towards unsustainable levels. Indeed, after declining to a low of around 4.8 percent in January 2012, the 10-year Spanish bond yield has again risen to 5.90 percent. Meanwhile Italian bond yields are back up to over 5.5 percent. Most economic analysts would consider that these bond yields are inconsistent with Italy and Spain's long-term public debt sustainability.
More ominously still, despite the European Central Bank's staggering largesse, the Italian and Spanish economies have now moved back into recession. Furthermore, high frequency data suggest that those economies' recessions are now deepening. The IMF current projection that those two economies will each contract by around 2 percent in 2012 might very well prove to be overly optimistic.
The increase in Italian and Spanish interest rates, coupled with the continued slump in their economies, sits very oddly with recent claims by European policymakers that the worst of the European economic crisis is behind us. To be sure, the ECB's LTRO program did avert a massive funding crisis for the European banking system by providing them with vast amounts of secure and very cheap three-year ECB funding. And the LTRO program also provided temporary support to the Italian and Spanish bond market and gave a sense of calm in the European financial markets by encouraging Italian and Spanish banks to use the cheap ECB financing to buy their governments' bonds.
However, what the LTRO program has not done is to restore the conditions for economic growth in the European periphery. In particular, it has not relieved countries in the European periphery from having to undertake draconian fiscal adjustment as part of the European Union's recently agreed fiscal pact. That pact is requiring countries like Ireland, Italy, Spain and Portugal to cut their budget deficits by between 2 to 3 percentage points of GDP a year in both 2012 and 2013. And this is being required of them in the middle of major domestic economic downturn and a deteriorating external environment, without the benefit of a currency devaluation to help boost their exports.
The LTRO program also has done nothing to address the European banks' capital shortage problem, which last June the European Banking Authority estimated at around EUR 115 billion. The latest ECB bank lending survey clearly shows that this capital shortage is inducing the European banks to restrict credit, which is compounding the deleterious impact on economic growth of major fiscal austerity. As the European economy sinks deeper into recession, one has to expect that the European banks' loan losses will only increase, which will cause these banks to cut back further their lending.
Far from being fickle as European policymakers are wont to portray them, markets are now correctly sensing that Europe's policy mix is highly pro-cyclical in nature and that weakening economies will make it very difficult for countries like Italy and Spain to address their public finance programs within the Euro straitjacket and without a debt restructuring. If the past is prologue to the future, however, one must expect that the European policymakers will blame the markets for delivering the message while they will continue to remain in denial about the bankruptcy of their policy approach to the European debt crisis.
Instead one must expect that the European Central Bank will find a way to pull yet another big rabbit out of the bag to kick the can further down the road. However, given how rapidly the effects of their massive LTRO program has faded, one would think that even the ECB must recognize that they are running out of road down which to kick the can. [Emphasis added.]
Desmond Lachman is a resident fellow at the American Enterprise Institute.
Mr. Lachman suggests at the end of the article that the ECB may be willing to extend more cheap loans to Spain and the other periphery nations of Europe, in addition to the €1 trillion it has recently doled out. That may be true but as we are now seeing, the perceived benefits of these bailout loans are increasingly fading.
The bond market is the ultimate arbiter on the subject of how much debt is too much. We saw it in Greece. We may be seeing it now in Spain. Italy may not be far behind, what with the recession unfolding across these nations and others in Europe. The same will be true in the US at some point, but that’s another subject for another time.
Spain Could Send Global Equities Into a Tailspin
On Thursday, Spain will auction another round of 2-year and 10-year government bonds. If the rate on these bonds rises above 6%, which is quite likely, this could put the European debt crisis right back on the front pages. If that is the case, this could roil stock markets around the world.
Italy has its next large bond auction on April 27. Spain has another large bond auction on May 3. Traders around the world will be watching these debt auctions very closely. Thus, it will not surprise me if the European debt crisis – which was supposed to be a non-event at least through the end of this year – roars right back onto center stage, if it hasn’t already by the time you read this.
Greece was one thing; Spain and Italy are quite another. Greece’s GDP is $301 billion; Spain’s GDP is $1.4 trillion; Italy’s is $2 trillion. As my old friend John Mauldin wrote in his letter on Saturday, “Spain is too big to fail and too big to save.”
The latest decline in the US stock markets began just as news of rising European bond rates began to surface earlier this month. Most everyone was surprised by the latest news which started making headlines last Friday. Here’s an S&P chart from freecharts.com:
If the upcoming debt auctions in Spain and Italy don’t go well, I expect this news will weigh heavily on stock markets around the world, especially since this problem was thought to be “fixed” for at least a year. This is precisely why you are not hearing a lot about this in the media. But if the yield on Spanish bonds is well above 6% on Thursday (two days from now), you will be hearing quite a lot about it very quickly.
There Are Times to be Defensive
In my February 21 E-Letter, I presented the performance records for the 13 professionally managed programs that I recommend. If you recall, all 13 have outperformed the S&P 500 Index from their inception dates through the end of 2011. More importantly, all 13 did so with significantly smaller losing periods along the way. All of the money managers I recommend lost much less than the S&P 500 did in the bear market of 2007-2009, and most lost less than half. As always, past performance isn’t a guarantee of future results.
I don’t know if the European debt crisis is going to explode into the headlines in the next few weeks, but we may know the answer in the next two days. I don’t know if Spain and Italy will become the next Greece, but we may know in the next few weeks.
US stocks just recorded the best 1Q since 1998, with the Dow Jones Industrial Average up 8% in the first three months of this year. So who am I to rain on this parade? But the stock markets began to decline earlier this month, just as news of rising interest rates in Spain and Italy began to emerge.
Making matters worse, trading volume on US stock markets has been the lowest in more than four years so far this year. Why is this important? When trading volume is low, it doesn’t take much to spark a new trend – in either direction.
Contrary to Wall Street’s mantra of “buy-and-hold” forever and ride out the losses, I believe that there are times when it pays to be have some of your money out of the market or at least hedge long positions. If Spain and/or Italy experience more problems selling their debt, it will almost certainly be bad news for equity markets around the world.
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