Submitted by NJB Deflator [18]
The First Cut
And so it begins...Last Friday the Spanish government published a proposal to cut government expenditure and raise taxes to reduce the fiscal deficit by 56.4billion euros by 2015. I have outlined why austerity will not work in Europe [19], but it looks like this is a lesson Europeans will have to learn for themselves--for a second time. The writing is on the wall in Ireland, who ailed in the same ways that Spain is currently ailing, but what Lord Merkel wants, Lord Merkel gets [20]. The immediate malaise from these austerity measures will be large-scale social unrest, which is already being planned by many of the 50% of the country's unemployed young people. Regardless of one's stance on the economic merit of austerity, what is indisputable is that riots are real and riots do not end well. With nothing to lose, this round of Spanish austerity protesting has the potential to end in catastrophe.
Also part of Spain's austerity measures are the country's plans to sell 100 regional commercial real-estate buildings to private citizens/businesses. This fire-sale is not expected to be met with substantial demand, which is nothing short of obvious. The stance of Spanish business owners is quite clear: with impossibly high and rising interest rates and an ever-climbing unemployment rate, entrepreneurs are not interested in taking on the risk of expanding or starting new businesses amid economic and political uncertainty. The regions' real-estate sales will likely do nothing more than saturate already soggy land prices and contribute to depleted demand driven deflationary forces.
And if the austerity hysteria is not enough, the ECB came out swinging over the weekend and stated that senior bond holders of Spanish bank debt would hold subordinated creditor status to the 100billion euro ECB bailout...First riots in the streets, now riots in the credit markets! As part of the Irish bailout, senior creditors were spared losses; the unprecedented nature of such a shake-up in the Spanish bailout deal will not be taken lightly. Credit default swaps (CDSs) on Spanish banks immediately surged on the news; if this haircut is enacted, many Spanish creditors will pull funding from the capital-stricken country and will even further elevate the country's borrowing rates. For some perspective: Ireland granted senior creditors the same status as the bailout fund in 2010, and it still took them over two years to regain access to the debt market. Spain's subordination of senior debt holders will have similar effects, but these effects may be felt even before the bailout is drawn upon. Needless to say, the Spanish bailout is by no means a sure thing at this point, indicated by Spanish bankers who lamented and were confused by the weekend's news.
 [21] |
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| Top lines: Spanish 5yr bond yield (orange) & Banco Santander 5yr Credit Default Swap (green) -/- Bottom lines: IBEX 35 (yellow) & German 5yr bond yield (salmon) |
In other, equally gloomy news, the latent rolling downgrades and downward growth revisions [22] that I wrote about on the eve of the "Spanish bailout" are coming to fruition: GDP growth forecasts continue to be slashed by global agencies. Over the weekend UK GDP growth was revised to 0% from 0.4% by Ernst & Young Item Club (who uses a model similar to that of the UK Treasury) just days after the Bank of England announced further stimulus measures. Recent attempts at bolstering markets through promises of easing seem to be failing in the UK, and even in the US investors are starting to question whether markets are amenable to quantitative easing.
It was also reported today that London home prices fell by a record 3.6% from June due to excess supply...Good luck with those real-estate sales, Spain. The lynch-pin of the recent pessimism was the IMF's downward revision of global annual GDP growth to 2.3% to 2.4%. Expect negative revisions to continue; they are usually a lagging indicator of economic health. Warren Buffet says to expect municipal bankruptcies to become more frequent. Now that the stigma is gone, he says, more municipalities around the country will admit defeat. We focus a lot on California, but municipalities in Texas, Alabama, Oklahoma, and Nebraska are just as bad, if not worse than those in California.
The single scariest aspect of the financial paradigm is the idea that QE3 will have little effect on markets. The change in attitude towards a third round of easing by the Fed over the past couple weeks is almost palpable, and while most agree that we need it, not as many believe that it will heal all. The fact that we are relying on easing to propel us to new highs is not inspiring, and it puts Bernanke it a difficult spot: don't ease and capital markets collapse; ease and risk hyperinflation. Bernanke will likely engage in a nontraditional form of easing--something other than LSAP. No matter what he chooses, though, the riskiest outcome of any monetary policy is stagflation. There is a non-negligible threat of excess capital working through the economy giving way to inflation as unemployment continues to rise and output remains depressed. This notion is corroborated by today's retail sales numbers which showed that June sales were down 0.5% from the month prior. This is the worst three month streak in retail sales since 2008.
I will be in Spain, the Czech Republic, and Turkey until August...detailed reports to come.