Spanish problems continue
Kiron Sarkar
April 15, 2012

Chinese 1st Q GDP declined to +8.1% YoY (the slowest pace in 3 years), below forecasts which ranged from +8.3% - 8.4% and below the +8.9% reported for the 4th Q of 2011. However, most analysts believe that Chinese growth will bottom out in the 2nd Q of this year and will pick up in the 2nd half of 2012. Rumours continue to circulate that the authorities will introduce stimulus measures, though much higher than expected lending by banks in March (US$159bn), suggests that the authorities have already embarked on such measures - bank lending is very much controlled/directed by the authorities. In addition, urban and rural wages rose by 9.8% and 12.7% respectively in real terms YoY in the 1st Q. Furthermore, the Government has been offering subsidies for the purchases of cars and household appliances. Premier Wen stated recently "We must strengthen our back-up plans and make room for contingency policies, ensuring that we are well prepared for difficulties and challenges". In particular, given the very serious political issues recently, following the removal of Mr Bo and the fact that there is going to be a major change in leadership later this year, the Chinese authorities will not want any economic problems to increase current tensions;

The PBoC has doubled the trading range of the Yuan/US$ to 1.0% of the daily official rate. Analysts continue to report that these are the 1st steps towards full currency convertibility. Personally, I continue to believe that the real reason for this change is that the Chinese authorities remain highly concerned about an appreciation of the Yuan (particularly against the Euro, as Europe remains China's largest trading partner) and are trying to slow down and/or even reverse the appreciation. Going to be interesting in an US Presidential election year;

Iran and the 6 world powers are set to meet again in 6 weeks time to try and resolve the nuclear issue. No conclusion was reached during the 1st meeting, though unlike earlier discussions, the Iranian side did not set any pre conditions. It is clear that the 6 powers are keen for Israel not to pursue military action, which will have a material impact on the Oil price - President Obama, in particular, is not at all keen for Israel to intervene militarily as a high oil price will harm his re election campaign. However, if discussions do not result in a meaningful outcome within a reasonable period of time, Israel will become more emboldened to pursue military intervention, especially as they have greater leverage in an US Presidential election year. However, in the short term, the price of oil should decline as discussions continue;

The WSJ reports that Spanish banks gross daily borrowings from the ECB averaged E316.3bn in March (E169.9bn in February). They accounted for approximately 28% of the ECB's two 3 year LTRO programmes which, in aggregate, totalled approximately E1.1tr. It is clear that the Spanish banks have been buying Spanish Government bonds in an attempt to play the carry trade - estimated by the WSJ at E40.6bn YTD. Complete madness, as yields on the 10 year Spanish Government bonds rose to 5.99% last Friday (up 21bps on the week and some 47 bps over Italian equivalents), which suggests that these banks will have incurred material losses on their purchases of Spanish bonds. However, it looks as if the Spanish banks have run out of cash and will not be able to buy additional Spanish bonds - Whoops - cant see anyone (in the private sector) being a material buyer of Spanish debt, other than short term instruments. Whilst Spain has been clever in prefunding a significant part (around 50%) of its 2012 financing requirements, it is going to have a real problem financing the balance. In addition Spain and for that matter, Italy, have been borrowing at the shorter end to avoid higher longer term rates. In due course, these bonds will have to be refinanced. Whoops again. However, Italy's average debt maturity profile is far higher than Spain's. There is no doubt that Spain will need a bail out.

It will be interesting to follow the auction of 12 and 18 month Spanish treasury bills on Tuesday and, in particular, the proposed 10 year auction on Thursday. The amounts to be raised will be announced tomorrow.

Will the ECB have to restart its SMP programme - looks very likely, though the German's are going to hate it - however, they cant block it, as they have just 2 representatives on the 23 member committee. In the past, a rate of 7.0% for the 10 year bond has been seen as the moment EZ countries have to seek bail out funds. Unless the ECB starts buying Spanish bonds, a rise to 7.0% looks inevitable, increasing the losses for the Spanish banks who bought their Government bonds recently. Whops yet again.

The current situation is untenable. Yes the IMF is likely to provide some funding to increase the size of the EZ bail out funds (announcement this week), but the MD of the IMF, Lagarde, has been down playing the size of the bail out funds that will be available to the EZ in recent days, though a number of observers believe that the IMF will raise an additional US$500bn - however, not all can be allocated to the EZ. As a result, the total amount of EZ/IMF bail out funds available will simply be insufficient, though an initial relief rally is certainly possible.

The ECB remains the only game in town. However, even with the ECB buying more Spanish bonds, the problems within Spain remain. Spain's projected budget deficit of 5.3% for the current year is impossible to achieve - it will be closer to 7.0%. The Spanish Government has introduced legislation which allows them to intervene if the regions overspend. The measures will be strongly resisted, but the regions need help from the Central Government to help pay the E35bn of unpaid bills they have accumulated to date. Spanish CDS's rose to a record high - approaching 500bps on Friday, up from 380bps at the end of 2011. Furthermore, austerity without growth is just going to make the situation much much worse. Spanish debt to GDP is way higher than the official number of approximately 70% - at least over 85% - indeed, a number of analysts argue that it is (well?) over 100%.

The ECB is likely to reduce interest rates, though inflation remains above the target of 2.0%. However, when EZ interest rates are reduced to near zero, what do they do next. Money printing on a grand scale is the only option, though Germany will be strongly opposed, as inflation will rise much much more. Spain is simply too big to rescue and too big to fail - there lies the dilemma.

The Spanish authorities are also introducing measures to criminalise those involved in street protests that "seriously disturb the public peace", which suggests to me that there is going to be a lot of civil strife in coming months. A ban of cash payments involving E2,500 and a requirement to report foreign bank accounts (to avoid tax evasion) has also been introduced.

There are no easy options. The bottom line is that Spain will need to be bailed out, in spite of their daily denials. However, it's economy will continue to collapse.

The Euro - well, forget the current level of US$1.3075, much more likely US$1.20/1.10 or even lower - parity? by the year end;

Italian labour Unions protested against Mr Monti's pension overhaul on Friday. The rise in the retirement age leaves a number of people who elected for early retirement, without a pension. It looks as if the authorities will cave in, with a resultant cost of E10bn, according to the head of the Italian pension agency. There is speculation that the Italian Government will introduce a wealth tax;

UK March producer prices rose by +0.6%, higher than the +0.5% expected and by +3.6% YoY (+4.1% in February). Input prices increased by +5.8% YoY, reflecting higher oil costs, in particular.

S&P reaffirmed the UK's AAA rating, with a stable outlook, unlike Moody's and Fitch, who have both warned that the UK may well lose its AAA rating. S&P stated that the stable outlook reflected their view that the UK Government could continue to reduce debt, that net debt to GDP will stabilise in 2014 and that "economic recovery will gain traction over the medium term" However, they reported that the budget deficit would amount to 4.0% this fiscal year, higher than the 2.9% predicted by the Government;

The University of Michigan's confidence index dropped to 75.7 in April, from 76.2 in March and worse than the unchanged expected. The weaker NFP data, combined with lower earnings was cited as the reasons for the decline. The current conditions component declined to a 4 month low of 80.6, from 86 in March. Consumer expectations (6 months ahead) rose to 72.5, the highest since September 2009, from 69.8 in March, however. Helpfully, inflation expectations over the next 12 months declined from +3.9% in March, to +3.4% in April. In addition, lower prospective petrol prices and improving employment (assuming the March NFP data does not reflect a weakening trend) should help confidence data in future months. However, the continued problems in Europe may well impact and I remain of the view that the FED will introduce QE3 in coming months;

Difficult day for markets on Friday in Europe and the US and I expect further weakness on Monday. The IMF/G20 meetings are unlikely to produce any major news, though an increase of the EZ bail out fund, by the IMF is likely. The IMF will release its global economic outlook on Tuesday. The 1st round of the French Presidential elections is scheduled for next Sunday (22nd April), with the 2nd round 2 weeks later. Mr Sarkozy is expected to win the 1st round, though polls suggest he will lose the 2nd. However, my informed friends continue to believe that Sarkozy will win the 2nd round.

I remain bearish.

Kiron