Daniel Lacalle

Close To The Edge Or The End Of The Tunnel

Decrease Font Size Increase Font Size Text Size Print This Page

(This article was published in Cotizalia on June 2nd, 2012)

Let me start from the end. We are arriving, slowly and with enormous difficulties, at the end of the tunnel. We simply don’t know it because the light at the end of the tunnel is not “back to 2007”. The end of the tunnel does not mean growing at 3% per annum, more debt, the stock market back at highs and holidays in Marbella. I expect a tough decade of adjustments and depressed valuations, because the world is slowing its growth. But it is a very healthy sign to see that Europe is finally exposing the skeletons of the closet, the need for recapitalization of the banking system and adopting the adjustments that the economy has demanded for years.

While the stock market plummets, driven by the weak data coming from the US, China and Europe, I would like to remind of what I always say. This market is a bad investment, but a good bet.

A few comments:

* Despite the fall of the Ibex in Spain, the valuations of most of its companies have not changed significantly relative to their European and global peers in debt adjusted relative multiples. It’s just that most are barely less expensive than they were a few years ago, when Spain traded at “high growth” premiums to peers. Look at the valuations of Russian, Chinese, Brazilian, French and American stocks that collapse every day… And debt is an important factor to curb expectations-hopes-prayers of takeovers. Because predators post-2008, after the value destruction of accumulated losses in corporate transactions, rarely seek to buy more indebted companies.  Remember that over 78% of all corporate transactions in Europe between 2005 and 2011 have been value-destroying, according to Morgan Stanley. The only way in which the Eurostoxx or the Ibex will go up will be when companies show growth cutting off debt.

* In May the bond and stock markets in Europe and emerging markets saw more than 30 billion euro in outflows. We can complain as much as we want about short positions, but what we have here is pure and simple selling. Especially from Long-Only funds.

* 2011 and 2012 so far have been the years with the lowest percentage of share repurchases by companies and executives since 1998 (source: Goldman). It is almost ironic that those who complain about the price of their shares are not buying.

* The greatest mistake of investors in these months has been to remain positioned in risky assets waiting for an elusive ECB, Fed or China stimulus. As a friend always tells me, the only ones who now demand a stimulus plan do so not because of the state of the economy, but to see stock markets rise. And of course, we forget the chart below (courtesy David Einhorn). More stimulus means more debt and fail again.

Spain. Rescue? What Rescue?

This week the successive set of global economic figures, almost all negative, has driven markets to panic mode. But with all due respect to the poor U.S. data, the slowdown in China and the debt crisis, what I find really surprising is to read that 57% of citizens in Spain support a rescue package from the IMF or ECB, because it shows that much of the population supports more stringent austerity measures and the budgets cuts that would be imposed with a rescue package, as we have seen in Portugal. Let’s not forget that any bailout will be done to strengthen the creditworthiness of the country and that means cutting the large expense items -pensions, unemployment support, public sector. In fact, the largest additional effort that will be demanded by the EU, IMF and anyone that’s going to pay for the rescue will be a meaningful reduction in the public sector.

The world is aware that the 5.3% deficit target for 2012 is unachievable, since the estimates of revenues looks too optimistic. More taxes have proven to generate limited or negative revenue growth. The Laffer curve shown in all its glory again. So what will be critical will be to focus on reducing overheads (ministries, councils, subsidies, etc..), liberalize some sectors and cut energy costs.

But what surprises me most is to see how little liquidity is available in the global system to put out financial fres when they become as large as Spain. Last week we talked in this column about the huge debt that the Fed and the ECB hold, and their problems. But the IMF now has just 330 billion dollars of funds available, from a total of $560 billion, almost all of it debt-financed in New Arrangement to Borrow (NAB) , and the veto of both the UK, Canada, United States and China, who refuse to provide more funds, given their own specific domestic debt issues.

A lifeline to Spain of $300bn would consume most IMF funds, and make it impossible to prepare for a solution for Italy, for example. This does not mean that the IMF with the ECB could not provide an appropriate credit line, but a full rescue package seems unaffordable. 

Incidentally, it is striking that in the orgy of debt of the OECD, the IMF has gone from providing support packages of 20 to 30 billion dollars to now talking about figures that are ten times higher to historic ones. 

How to solve a problem called Spanish banks?
All this intense support that the Spanish government is negotiating is to finally make an attempt to clean up the financial system after years of denial saying stubbornly that it was the best and most effectively regulated banking sector in the world, with no sub-prime. A final attempt to limit and clean the real estate exposure, therefore trying to stop the current effect of “contagion and collapse”. Contagion of bad non-performing loans on the rest of the portfolio of credit of banks and collapse of new credit to the real economy.The announcement by Bankia of its capital needs 23.5 billion euros, has revealed two things:

1) When it comes to provisions, the term that the ordinary citizen sees is “revealing losses”. If, as Draghi said on Thursday, banks subject the country to a steady increase of the amount needed for provisions, it creates uncertainty, lack of credibility and suspicion. A slow drip of bad news does not reduce risk, it multiplies the confidence problem . Markets sell the shares and there is a risk of an outflow of deposits. It is better to err by excess of prudence than to wait for markets to forget the  previously published figure of real estate losses and see if it works.

2) The need to recapitalize Spanish banks probably reaches 70-80 billion euro, according to Nomura and Morgan Stanley. As always, Goldman Sachs, optimistic as they are, see only an estimated 17 billion euro of capitalization needs. Anyway you see it, an enormous figure that makes Spain “impossible to bail-out”. And even Goldman warns that banks may be spending up to 6% of Spain’s GDP annually to finish building houses and homes to avoid having to make higher provisions (if properties are finished the provisions required by law are substantially lower).

Therefore, Spain can not afford a Swedish solution, public money to bail out all banks and remove their toxic assets, given the monstrous amount of exposure to real estate of banks, and given the current level of government debt. Issuing public debt to fill the capitalization gap of banks could prove to be extremely damaging to Spain’s already high cost of borrowing.

A possible solution comes from a Bail-In with limited public cost. Forcing a conversion of debt into shares, even though banks dislike this measure due to the massive dilution that would result for their shareholders. The Instituto Juan de Mariana points precisely to that solution , which I also commented on twitter and in this column. Debt To Equity Swaps. An internal recapitalization, forced conversion of debt into equity, which affects only the bank’s shareholders, not the taxpayer, rather than a public bailout, which would be unaffordable and extremely costly. 

A bail-in has the advantage that the bank loses the perverse incentive to return to making lending “mistakes”, “knowing” that it can be rescued with public money. As the bail-in affects its shareholders the most, they will be the first ones to force the bank management to behave appropriately in future lending.The solution is difficult and slow, but once Spain has finally imposed severe recapitalization measures the light at the end of the tunnel will be evident, as seen in other countries.

Confidence and credibility

In a country that has withdrawn billions of deposits from their banks in the first quarter according to the Bank of Spain, Spanish mainstream media (chiefly La Razon, Publico and ABC) still has the audacity to blame the international press, the Anglo-Saxon evil papers, and “speculators” for the decline in its stock market and the rise in bond yields. Blaming the wicked investors who Spain so desperately needs to buy its debt, or the foreign press, by the way, the same press that criticizes openly and aggressively Obama, Bush, JP Morgan, Goldman or Cameron. Yet the headlines “Spain under attack from speculators” and “the attack of anglosaxon press to our banks” is repeated like a mantra in different forms.

The beginning of the solution to Spain’s problem is foreign capital and we must attract it. When I hear atrocities about “scavengers” (on Spain’s public TV) referred to international investors I think that Spain’s media -unwillingly- is at risk of sabotaging the government efforts to seek funding and solutions.

The truth is that I have never seen any business / country prosper and be sustainable on the strategy of telling their clients / investors that they are ignorant and publicly blaming clients for the slowdown in sales. Nor have I ever seen a market that values ​in a positive way a constant change of targets, or missing them, even by a few decimals. Investors can not make acts of faith, because they are not allow by their own customers. If there is no trust, there is no investment. And if the country is not well understood, is it not our fault for not explaining ourselves clearly?

I live in London. Spain is a country valued for its solid corporations and professionals. Hard workers, serious and humble. This media concept of “they do not understand us” or “they attack us” parts of two very dangerous vices that were not typical of Spain. Arrogance and ignorance. The arrogance of thinking that we deserve the attention, forgiveness and eternal capital of investors, no questions asked, and ignorance of what happens globally, which is that almost all OECD countries are in trouble and that the money available is reduced by a deleveraging world.

Spain should not settle on being “one of many bad countries” but we have, precisely because of our current difficulties, to do our homework faster and better . Because we do not judge ourselves. We tend to see ourselves more beautiful, slimmer and with more hair than it is real. We are judged by the world.
Investor confidence can not be recovered in five months. We can not demand that speed. Trust will be recovered with hard figures, not of a quarter, but those of 18-24 months. I’m sure Spain can do it.
Originally published in Cotizalia.
To watch my interview in Al Jazeera about the Spanish banking issues go: (Quicktime or Oplayer required) http://dl.dropbox.com/u/62659029/iv_daniel_lacalle_250512_0.mpg

And my interview on Spain’s bailout

http://www.aljazeera.com/programmes/insidestory/2012/06/20126126534386935.html

Further reading:

Eurobonds? No Thanks. Debt Isn’t Solved With More Debt: http://energyandmoney.blogspot.co.uk/2011/11/eurobonds-no-thanks-debt-isnt-solved.html#

What happened to put Spain on the verge of intervention?: http://energyandmoney.blogspot.co.uk/2012/04/what-happened-to-put-spain-on-verge-of.html
Why Italian and Spanish CDS can rise 40%… and Greece is not to blame:

http://energyandmoney.blogspot.co.uk/2011/11/why-peripheral-cds-can-rise-40-and.html#

The Spanish Banking reform
http://energyandmoney.blogspot.co.uk/2012/05/spanish-banking-reform-and-devils.html

One Response to Close To The Edge Or The End Of The Tunnel

  1. Anonymous 7 June, 2012 at 1:50 am

    nice posting.. thanks for sharing..

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *