For a year that started with one of the best first quarters in history, the second quarter has proven to be something of a disappointment.
On the first trading day of June, the U.S. averages had their worst performance of 2012, pushing the Dow Industrials into negative territory for the year. The S&P 500 is still positive for the year…albeit barely.
Interestingly, Spanish stocks—which have been at the center of the European financial crisis that has been roiling the markets—finished the day roughly flat. Sizemore Capital continues to allocate funds to select Spanish stocks, and the relative calm in the Spanish market gives us hope that much of the selling there has already been done. Spain is home to some of the world’s finest multi-national companies, and the state of crisis has created absolute steals that we may not see again in our lifetimes.
The Sizemore Investment Letter Portfolio holds positions in Telefonica (NYSE:$TEF) and Banco Santander (NYSE:$STD) and has additionally sold out-of-the-money puts on both. (See “How to Keep Your Cool While Investing in Europe” for more details on our put strategy.) Additionally, the Tactical ETF Portfolio holds a position in the iShares MSCI Spain Index ETF (NYSE:$EWP).
More than even bad news, markets hate uncertainty. And the uncertainly about the Eurozone’s future has wreaked absolute havoc on Spanish and European shares.
Spain’s effective nationalization of the ailing Bankia—the country’s third largest bank by deposits—had precisely the opposite effect of what you might have expected. Rather than cheer the fact that the Spanish government is taking the crisis seriously, it simply raised new questions about the Spanish state’s ability to afford the bailout of its banking sector.
The way forward is becoming increasingly obvious. As The Economist wrote this week, “Spain’s problem is one of misdiagnosis.”
The focus of the Spanish government and of the broader European Union (and particularly Germany) has been austerity. The thinking is that budget deficits must be slashed in order to restore investor confidence. The case of the United States—where both debts and deficits are higher than in many of the EU’s problem states—proves that this is not entirely true. After all, the yield on the 10-year Treasury note recently hit levels not seen since World War II.
As The Economist continues,
“This fiscal focus gets things exactly backwards. Spain’s poor public finances, unlike those of Greece, are a symptom rather than the cause of the country’s economic woes. Before the crisis Spain was well within the euro zone’s fiscal rules. Even now its government debt, at around 70% of GDP, is lower than Germany’s.”
In Spain, it is all about the banks. Outside of Santandar and Banco Bilbao Vizcaya Argentaria (NYSE:$BBVA), Spain’s banks are by and large insolvent and in need of recapitalization.
Again, using The Economist’s figures, a recapitalization of €100 billion would be roughly 10% of Spain’s GDP. Borrowing this amount would still leave Spain safely below the debt-to-GDP levels of the United States, but the country would have to pay punishingly high rates of interest given current market conditions.
On a side note, the Financial Times estimates the cost of a banking bailout to be much smaller. The FT points out that roughly 11% of Spanish bank loans are non-performing, which is less than half the level of Ireland, the country whose predicament most closely matches that of Spain. At 350% of GDP, Spain’s banking assets are large by world standards, but again, less than half the levels of Ireland.
What is the most likely solution? The budding consensus would seem to be using EU rescue funds to inject capital into the banks directly, which Spain is now advocating.
Currently, this is not legal under EU rules. But as the last year and half of on-again / off-again crisis has proven, EU rules are a bit of a work in process.
In any event, the next week promises to be anything if not interesting. Mariano Rajoy, Spain’s prime minister, publicly announced support for EU oversight of national budgets, apparently in an attempt to sweet talk German chancellor Angela Merkel. Separately, the European Central Bank indicated over the weekend that it was “prepared” to intervene with bond purchases or additional bank assistance if needed. And encouragingly, late last week, the EU announced that it would be lenient in allowing Spain another year to get its budget deficits under control.
What does all of this mean to us as investors? In investing, as in many of life’s endeavors, it is always darkest just before the light. And it would appear that we’re starting to see a sunrise in Europe. Sizemore Capital will look for opportunities in the weeks ahead to profit from the resolution of Europe’s crisis.
This article was originally published as Sizemore Capital’s monthly market commentary for Covestor.