Spanish "Bailout" and Market Reaction: What's the Rally?
Over this past weekend the Spanish government secured $125 billion in bailout funds (Prime Minister Mariano Rajoy prefers to call it a line of credit) to secure the Spanish banks.
The goal was to “ring fence” the banks from any further runs, particularly in light of this Sunday’s Greek elections which could determine the fate of Greece’s future in the euro. The immediate reaction by the markets was quite positive. S&P 500 futures contracts were up 1.5% when the Japanese market opened last night; Asian and European markets were up roughly 2%.
While there have been some positive developments, Europe is still a long way from fiscal union. In fact, the announcement of the Spanish bank bailout may be more divisive than intended:
- When Ireland asked for a bailout for its banks, it was required to use the bailout funds to buy the bad debt off of the banks’ books—Spain is not being asked to do the same—Ireland is not happy;
- As noted above, Spain is characterizing the bailout as a line of credit with no strings attached, whereas the troika (European Central Bank, European Union and International Monetary Fund) have strongly suggested that they are managing the process just as they have managed the other bailouts;
- The bailout sets a new precedent which could become very costly as attention now moves to Italy—Europe’s third largest economy;
- It appears that the bailout funds will be senior to Spanish government debt which will only put more upward pressure on government bond yields; and
- This is yet another band-aid that buys some time but doesn’t really solve the underlying problem—slow growth, high unemployment, enormous debt and no fiscal unity.
Our inclination, as it has been over the past week of the market’s mini-rally, is to sell the news. We’ve reduced our equity exposure in clients’ portfolios by approximately 15% (e.g. if the portfolio had 40% equity exposure before, it now has 34% exposure). I’m sure there are those who are questioning why we are reducing equity exposures after the domestic market has already experienced a 6.5% decline and the international markets have declined even more.
In each of the past two years, with similar, but I would argue less threatening circumstances, the domestic equity market declined 16+% from peak to trough—that would suggest another 10% decline. I think that may be the best case scenario.
This time around the markets are dealing with:
- A sputtering domestic economy;
- A Chinese economy that has dramatically slowed down;
- A European recession;
- Another debt ceiling showdown in Congress; and
- Another Greek election this weekend, which even if the pro-bailout New Democracy party prevails again, does not guarantee a coalition government with a unified direction.
I’m sure we’ll get a rally if Europe continues to figure out ways to stem the flow of funds from the banks in the weaker periphery regions, as it did this weekend with the Spanish banks, to Germany. We may also get a couple rallies as European leaders once again profess their commitment to the Euro and understanding of the need for urgency, until they fail to follow through and/or push out the ultimate implementation of a plan. But, I don’t think all those risks are fully priced in the market; in fact, there seems to be a certain complacency that somehow the central banks will save the day again.
Unfortunately, the ECB doesn’t have that mandate nor does it have available to it the same tools the Federal Reserve has (i.e. an unlimited balance sheet). China probably has the wherewithal to manufacture a soft landing, but when is dependency on the government (and in this instance a Communist government, no less) a good thing for economic growth?
Finally, it isn’t clear to me that another round of Quantitative Easing would be good or effective for the domestic economy—mortgage rates are as low as they’ve ever been, affordability isn’t the issue. The last round of Quantitative Easing simply drove up the prices of commodities, in particular energy prices, to the detriment of other retail consumption.
As all these issues sort themselves out in one fashion or another, it will create a tremendous buying opportunity for equities; but, as long as uncertainty remains as high as it currently is across the global spectrum, we believe greater caution is warranted. We simply don’t think investors are being fully compensated for the prevailing risks.
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