All eyes have been on Greece and Italy in recent days, with only limited references to Spain in market commentaries. Yet Spain is the fourth-largest economy in the Eurozone, following Italy, and has the fourth-largest sovereign bond market. Spain’s national equity market – the BME Spanish Exchanges (Madrid, Barcelona, Valencia, and Bilbao) – is just a little smaller than Germany’s Deutsche Borse (market capitalisation at end September 2011, $1.02 trillion vs. $1.15 trillion). It is difficult to sort out the French, Dutch, and Italian national markets in World Federation of Exchanges data because of the mergers of the Paris and Amsterdam exchanges with Euronext, and Italy with the London SE Group.
Spain moved relatively early to respond to the Eurozone financial crisis and its homegrown bubble and crash in the residential construction sector. The reform and recapitalization of the weak regional banks, the “cajas,” has resulted in the reduction of the number of groups from 45 to 15. Addressing the need to bring government accounts into line, the Spanish have added to their constitution a cap on future deficits. In contrast to some other Eurozone countries, there has been an impressive political consensus with respect to planned fiscal adjustments and even much-needed institutional and labour-market reforms.
A national election will take place on November 20th. Polls indicate that Mariano Rajoy, who leads the opposition centre-right Popular Party (PP), will lead his party to win an absolute majority on Sunday over the Socialists and become the next prime minister. He is thus expected to get a solid mandate to carry out further, even radical, economic reforms. Rajoy has emphasised his commitment to the euro and to restoring confidence to the bond markets in Spain. It will be a long haul, given the headwinds facing the Spanish economy in a Europe that appears to be entering a recession. Nevertheless, this expected change of government will be a positive development.
Bond investors will surely be following the election results, yet thus far their concerns have not moderated. As this note is being written, the 10-year yield on Spanish sovereign debt is above 6% and the spread over the German bund is over 4%. This spread is more than double the 1.00 to 2.00 country risk spread that could be considered “normal” for a country with Spain’s profile. Of course, what is “normal” may now be somewhat higher because of the market’s reassessment of the value of credit defaults, as David Kotok explained in his Sunday, November 13 Commentary. Our friend Manuael Balmaseda, Chief Economist for CEMEX, has calculated that Spain’s debt is sustainable if the government’s credibility can be restored.
The Spanish economy was flat in the third quarter. Provisional GDP growth is estimated at 0.0%, and industrial production actually declined 1.8% year-over-year in September. The European Commission has just released a revised GDP forecast for Spain in 2012 of +0.7%. We think this may prove to be a little optimistic. Annual growth of +0.2 to +0.5% may be more realistic, considering the fiscal constraints still to come and the prospects of a credit squeeze. Spain does have a competitive, relatively efficient export sector, and export growth may allow Spain to avoid (just barely) the recession expected for a number of other countries in the Eurozone.
The banking sector is one of our concerns. The largest Spanish banks have been relatively well managed and are profitable. Nevertheless, they have been affected by the widespread difficulties European banks have encountered in obtaining funds in the wholesale market and the retreat of investors from European bank stocks. Also, Spanish banks will face a substantial challenge in meeting the upward-revised 9% Core Tier 1 capital requirement by mid-2012. The European Banking Authority estimates Spanish banks will need an additional 26.6 billion euros of capital, an amount second only to the estimated 30 billion euros needed for Greece’s banks. It is highly likely that banks will be forced to reduce their lending as a result.
According to the MSCI indices for national equity markets through November 14, the Spanish market’s performance has been considerably worse than that of Italy over the past three months, – 8.01% versus – 4.45%. This surprising result is probably due to the heavier concentration of financial institutions in Spain’s markets, 40.6%, as compared with the Italian market, 28.7%, according to the iShare country ETFs for Spain and Italy (EWP and EWI, respectively). This high concentration of financials has been a reason we have been reluctant to include Spain in our International and Global Multi-Asset Class ETF portfolios. The market will likely react positively if next Sunday’s election results are consistent with the polls. We, however, would like to see evidence in the bond rate spread that credibility is being re-established, along with more positive signals that the economy is recovering, before we return to this market.
Bill Witherell, Chief Global Economist
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