Editor’s note: Having had a chance to think about the proper balance between free and paid content over my holiday vacation, I decided to make a lot more material available only to paid subscribers, both silver and gold members. Silver posts will be quick hits, while the gold posts will be longer analyses.
This is a silver level post.
Spain is now fessing up that its going to miss 2012 targets as well as its 2011 deficit targets. Ambrose Evans-Pritchard writes:
Taking what he called a "sovereign decision", he simply announced that he intends to ignore the EU deficit target of 4.4pc of GDP for this year, setting his own target of 5.8pc instead (down from 8.5pc in 2011).
In the twenty years or so that I have been following EU affairs closely, I cannot remember such a bold and open act of defiance by any state. Usually such matters are fudged. Countries stretch the line, but do not actually cross it.
For Credit Writedowns readers, this should come as no shock because I predicted this months ago. Here’s the question though: what does this mean for investors?
My conclusion is that it means you need to continue to be wary of sovereign debt. However, it creates the opportunity for relative value or paired trades where you short sovereign debt and go long Spanish corporate debt. A company like Repsol with international operations won’t be harmed by the goings on in Spain and a company like Endesa can still make the grade because electric utilities are low beta, low risk entities. I imagine these companies’ bonds will outperform Spanish sovereign debt.
Regarding the real issues in Spain, the deal on the table is for Portugal and Ireland to continue fiscal austerity until they reduce deficits significantly. If the depression this creates causes them to miss fiscal targets, they are to redouble efforts under the watchful eye of the Troika, just as in Greece. Spain and Italy have more latitude because they are not in programs but they have a short leash.
As I said in the October post linked above:
Austerity cuts demand too much to have the positive effects on deficits in the short-term that Europe wants it to have. All of these countries are likely to miss their targets. And then the Troika ‘occupations’ will commence. Will they hammer out a ‘voluntary’ debt reduction in Portugal too? Will they look to force periphery governments to sell assets to foreigners? Any way you look at it, this is a combustible scenario which awaits Europe. And at this point, I fail to see the upside.
Spain hinted in January that it would miss targets (see here) and now we are reading about their coming clean on this. But the key here is, as I like to say, “Spain is the perfect example of a country that never should have joined the euro zone”. Spain (and Ireland) had a budget surplus and low government debt before the crisis. Spain (and Ireland) saw Maastricht Treaty compliance while France and Germany were over on both the deficit and debt to GDP hurdles. That tells you this crisis is not a government debt crisis. It’s a balance of payments crisis – and it can’t be fought off with austerity alone.
Moreover, not only Spain has been a model before the crisis and during the IMF program, unlike Ireland, Spain is too big to fail and so they can play brinkmanship in a way that Ireland cannot.
Bottom line: The austerity jig is up. Spain is balking and that is going to create a lot of policy uncertainty. Sovereign bonds (and bank shares) may underperform in that situation. My view is that the call I made on why Investors will buy Italian bonds after ECB monetisation is precisely why markets have run up. This run up is coming to a close. I still think dipping a toe in is the right thing to have done and to continue doing. But the situation is a lot more risk-off now.