April 13th, 2012 | By Nick Sargen
Until recently, government bond yields for both Spain and Italy had declined significantly from their highs in early December on the back of massive injections of liquidity by the European Central Bank (ECB) via its Longer-Term Refinancing Operations (LTRO). This program, in which the ECB extended large amounts of 3-year credit to financial institutions at a 1% interest rate, has been credited for alleviating Europe’s financial crisis, because it lessened investor concerns about the ability of European banks to finance their operations.
More recently, however, market commentators have raised questions about whether the LTRO program will be effective over the long-term. These doubts are highlighted in a recent article by John Plender of the Financial Times (April 11, 2012) in which he discusses the implications of the program as follows:
“That underlies a fundamental problem with the ECB’s great liquidity injection. It reinforced the incestuous relationship whereby undercapitalized eurozone banks propped up overstretched sovereign borrowers who stood behind those same fragile banks. In Spain’s case foreign investors have been deserting the bond market and domestic banks are finding it harder over time to plug the gap.”
Viewed from this perspective, one of the shortfalls of the LTRO program is that it deals with liquidity issues confronting banks but not long-term solvency issues.
Trend Macro’s Lorchan Roche Kelly, however, offers a more sanguine perspective, when he writes (April 11, 2012):
“We remain confident in the largest Spanish banks. It is already clear that smaller cajas are going to need continued support…But while this will lead to unhelpful noise, the largest Spanish banks are cautiously optimistic.”
While the ECB LTRO-led rally in sovereign debt has faded for good reason, we still think the sell-off in the banking sector is overdone. Euro area banks are once again being priced as though they will be destroyed in a Lehman-type funding crisis – yet the LTRO operations are a 3-year advance commitment of funding that virtually rules out that risk. They deserved to be priced at least as zombies – not as though they were completely dead.”
My bottom line on this issue is that I side with Kelly’s assessment: While Spanish banks, especially the cajas, have longer-term issues and require greater capital, the ECB under Mario Draghi will take whatever action is needed to buy time for them to undertake these changes. In this respect, Draghi’s posture is very similar to Fed Chairman Bernanke’s: Draghi is not willing to see the European financial system collapse under his watch.
A second reason that Spain is in the news is that the government has not been able to meet its budgetary targets, mainly because the economy has slipped into recession and revenues are weak. On this issue, the views of Plender and Kelly are more compatible.
Pender, for example, offers the following assessment:
“Spain now finds itself at the centre of a great eurozone laboratory experiment designed to show a pro-cyclical increase in fiscal austerity that can lead on to growth and debt sustainability. Markets, which are wrongly assumed always to favor the fiscal hair shirt, are torn on this issue. They responded badly to the rise in Spain’s forecast 2012 budget deficit to 5.8 per cent of gross domestic product from the previously agreed 4.4 per cent, even though this still represents a reduction of 3.2 percentage points of gross domestic product.”
Kelley, by comparison, weighs the situation as a mixed bag. On one hand, he is disappointed that the budgetary measures the Spanish Government targeted – tax rises, spending cuts – can be seen as traditional “austerity.” However, he points out that the government has also introduced historic labor market reforms and is implementing supply-side measures called for by Mario Draghi. Kelley concludes by noting that similar reforms were implemented in Germany in 2003, and have proved to be critical to that country’s improved economic performance since then.
In short, I think it is a mistake for investors to focus on whether Spain meets its arbitrary budgetary targets while the economy is in recession. The more relevant issue is whether it will stay committed to the structural reforms it has embarked on. Above all, remember that the Spanish Government has credibility, which the Greek Government never had. Therefore, I don’t expect the situation to become as dire as Greece’s.
The main investment implications of what is happening in the euro-zone today is that the period of unusual calm is over, and we are entering a period of increased volatility. Furthermore, sentiment could deteriorate further if recessionary pressures build in Europe. That said, we are not altering our overall investment strategy and shifting to a more defensive posture at this time, because we do not foresee a return to the crisis mode of last year.