Much has been made, and rightly so, of the echoing crisis that is evolving in Spanish bank and sovereign credit (and equity) markets in the last few weeks. The impact of the LTRO on the optics of Spain's problems hid the fact that things remain rather ugly under the surface still and with the fading of that cashflow and reach-around demand from the Spanish banking system, the smaller base of sovereign bond investors has shied away. Stephane Deo, of UBS, notes that while the Spanish budget is a positive step (with its labor market reforms), Spain's economy remains weak and will face a severe recession this year followed by still significant contraction next year. However, he fears the measures announced may not be enough to calm investor angst as he doubts the size of fiscal receipts numbers and the ability to half the deficits of local authorities. Furthermore, the measures will have a large impact on corporate earnings - implicitly exaggerating the dismal unemployment numbers (which is increasingly polarizing young against old) with expectations that the aggregate unemployment rate could well top 26% and youth well over 50%. This will only drag further on the housing market, which while it has suffered notably already, is expected to drop another 25% before bottoming and credit is contracting rapidly (compared to a modest rise overall in Europe). Spanish banks remain opaque in general from the perspective of the size and quality of collateral and provisioning and Deo believes they are still deep in the midst of the provisioning cycle and tough macro conditions will force restructuring and deleveraging. Spain scores 5 out of 5 on our crisis-prone indicator and markets, absent intervention, are starting to reflect that aggressively.
UBS: Spain After The Budget
A few months ago we wrote a piece on Spain (see “Next on the watch list: Spain” 11 November, 2011) as we thought the market was way too sanguine on the Spanish risk. Since then our three worries have become bigger if anything: the deficit slippage last year was larger than expected, the GDP this year has been revised down since then, while the banking system still needs further resolution, in our view.
From a macro economic point of view, Spain remains weak; it will face a severe recession this year followed by another contraction next year. We also believe that the adjustment in house prices is far from finished. By contrast, we present the labour market reform which is a positive. On paper, the deficit reduction target is ambitious: a 3.2ppt decline from 8.5% to 5.3% with credible macro economic assumptions; GDP is expected to contract by 1.7%, with domestic demand down by a striking 4.4%. This fiscal consolidation is a step in the right direction. We think, however, that the measures announced might not be sufficient: some fiscal receipts numbers could be too high; we also have doubts on the planned halving of the deficit of local authorities.
The government plans to capture €5.4bn from these new measures which compares to the €17bn corporate receipts captured in 2011 or €30bn net profit generated by Spanish IBEX-35 stocks. Several measures affect corporate taxes: 1) Financial expenses will be deductible up to 30% of gross EBIT. 2) Depreciation rates will be regulated. 3) Upfront fraction payments are newly implemented. 4) Goodwill amortisation reduced from 5% to 1%. 5) Tax on repatriation of foreign subsidiaries dividends which are based on tax havens.
We believe that the Spanish banking sector is likely to require further writedowns of loans and real estate beyond what is being enforced by the recent change in provisioning rules by the Government. In addition, we expect the system to continue to make a strong and sustained effort in re-balancing its balance sheet through de-leveraging and replacing short-term wholesale funding (inter-bank, ECB, commercial paper) with more stable sources (time deposits, long term bonds).
Concerns are likely to remain over the extent of the problems facing the banking system, and we believe it will take some time to demonstrate to the market that spending has been cut at both the regional government and central government levels. The path of Spanish bond yields for the next 9 months depends a lot on changes in growth expectations, not only in Spain but also elsewhere in Europe (and indeed globally). Without growth expectations turning up significantly, we expect the structural deficiency of demand for bonds to re-establish itself in the form of higher sovereign yield spreads in the shorter term.
Top-down Macroeconomic outlook - prepare for a big decline in GDP
[15]
Given The Output Gap - unemployment will increase to well over 26%
[16]
But as we have noted before remains massively polarizing for the youth...
[17]
And while housing has dropped around 20%, it is expected that it has 25% more price depreciation to go (while in reality many question the government data that reflects this relative modest price drop relative to 50-60% drops in Ireland for instance)...
[18]
and bank credit extension is falling dramatically - with loans to households very negative YoY...
[19]
leaving banks increasingly the only marginal buyer of sovereign debt as foreign ownership plummets...
[20]
So in summary, a quick scorecard for the crisis-factor in Spain:
Government Bond (unaided access to public funding markets) - Fading rapidly - Check!
Housing - Prices down hard but falling further and reaccelerating - Check!
Unemployment - rising, accelerating, and increasingly polarizing youth - Check!
Banking - Opaque, unclear collateral, restructuring likely, deleveraging needed - Check!
Credit (the juice to keep growth going) - declining rapidly and negative - Check!
But apart from that...