Wednesday, April 18, 2012

How much more pain in Spain?

The headline read: Ray Dalio's Bridgewater Says Spain Is Worse Off Than It Was Before The LTRO. Simone Foxman reports Ray Dalio of Bridgewater Associates believes that:
The fund argues in a recent note to investors that Spain is even worse off than it was before the ECB announced its two LTROs in December.

Dalio argues that the tenuous circle of fragile Spanish banks providing funding for the Spanish government which in turn supports the troubled banks is swiftly eroding, if not vanished already:
I have argued in the past that the European Elites have a Grand Plan, consisting of austerity and structural reform, combined with a compliant ECB as long as the first two initiatives are followed. Foxman reports that Bridgewater believes that any policy response will be complicated:

  • Dalio and his team believe that since the burden is being shifted to the public sector and domestic banks, we will be less likely to see the kind of private sector debt restructuring used in Greece.
  • They also predict that EU leaders could soon tire of the slow progress of Spanish bank mergers meant to clean up Cajas' balance sheets.
  • Dalio believes that EU policymakers remain committed to ill-fated attempt to "save almost everyone" by using under-capitalized bailout funds like the European Financial Stability Facility.
  • But they will also have to act in a much more of a hurry than they previously believed, given Spain's predicament. This will show the inadequacy of currently budgeted resources to deal with the problem, and could pain EU leaders' abilities to deal with crisis problems in a negative light.
  • Ultimately, Dalio thinks, trying to save Europe without restructurings will prove to costly, and EU leaders will have to accept that more restructurings will be necessary.
In other words, a policy response will have to be quick. It will be complicated, but not impossible. Megan Greene of RGE says that a Spanish bailout is pretty much inevitable:
If Spain is unable to regain market confidence, will it be pushed into a bailout programme? Not immediately, but this does seem inevitable. The good news as far as Spain is concerned is that the country has already pre-funded half of its debt rollovers for 2012. Even if Spain faces unsustainable borrowing costs, it will not actually run out of cash this year.

Furthermore, the ECB will not stand idly by while Spain is forced into a bailout programme. At the very least, the ECB will step up its Spanish bond purchases through the securities markets programme (SMP). While additional long-term refinancing operations (LTROs) are unlikely so soon after the three-year LTROs were offered, the ECB may take further steps to prop up the ailing Spanish banking system.

While ECB intervention could buy some more time for Spain in the short-term, it is extremely unlikely to fundamentally change Spain’s fiscal or economic trajectories. In the absence of economic growth, Spain will eventually be forced to request official financing, potentially as early as next year.

Italy, 2011
Consider the recent history of the eurozone. Despite the dire headlines, the eurocrats were able to avert a catastrophe in 2011. Take the case of Italy, which was considered to be too big to fail but too big to save. A look at the MIB Index, which represents a broad index of Italian stocks, show that the MIB plunged and tested the technical support level offered by the lows in 2008  2009 - and support held.

Spain, 2012?
If you were to believe that the eurocrats have a Grand Plan for Europe (and there seems to be convincing evidence that there is one), then the most likely scenario is the northern Europeans hold peripheral country governments' feet to the fire in order to enact Grand Plan reforms, e.g. Spain plans to strip regions of powers in bid to calm markets. Were a real financial crisis were to hit, however, the authorities (e.g. the Troika) would come to the rescue and take steps to kick the can down the road a little bit more.

This would suggest a highly speculative trading strategy. Wait for the the IBEX Index, which represents Spanish stocks, to test its 2008 2009 lows - and then buy and wait for the cavalry to come over the hill.

Currently, IBEX has taken out its 2011 lows, but has not yet tested its 2008 2009 lows. Should such a test occur, the risk/reward ratio would likely be favorable enough to put on this highly speculative trade. For North American based investors, there is a Spanish market ETF available (EWP). Banco Santander (STD) is also US-listed.

If I am right, then there isn't very much downside to European equities. If Dalio is right and the European authorities "have to act in a much more of a hurry than they previously believed", then the crisis will be upon us sooner than anyone expects. In that case, maybe we should getting ready to buy in May?

Warning: Such a trade is highly risky and anyone who enters into it should size their positions carefully in accordance with their own risk tolerances (which may mean a zero position). If you were to put on such a trade, I would suggest that you enter a stop loss at 5-15% below your entry point in order to limit your downside. The risk/reward ratio should be favorable, but in this case, we would be playing the odds and the upside potential, though considerable, is highly uncertain.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Onlooker said...

Interesting take on this. Just one thing, all your references to '08 lows should instead be '09 lows.

I read your blog all the time. Thanks for your efforts here.