Risk Off, Or Just a Hiccup?

Markets have been jittery in recent days, especially around fears that the simmering embers
of the Euro Area debt crisis might be about to reignite. Bond yields in both Spain and Italy
have risen this week, while concerns continue to hover about whether a calm solution to the
tangled web surrounding the Cyprus bailout issue will be found.

Fears have been rising that Silvio Berlusconi will once more become kingmaker in Italy, but
surely this week’s headlines have been grabbed by Spain’s prime minister Mariano Rajoy, and
the slush fund accusations in which he has become enveloped. “All the accusations are false,”
he told journalists in his Berlin press conference with Angela Merkel, “except for some things
which have already been mentioned in the media,” leaving the audience trying to work out
whether in saying this he was trying to cover his back, or all that was in question was a clumsy
choice of words. Either way, markets remain unimpressed and the doubts will continue to
linger as long as Mr Rajoy remains prime minister.

Leaving aside the rights and wrongs of the case, what is most important from an investor point
of view is that Spain is now most likely facing a protracted period of political uncertainty. The
cleanest situation would be for Mr Rajoy to step down in his country’s interest while the issue
is clarified, and the ruling Partido Popular elect a new leader, one untainted by the scandal.
But this isn’t likely to happen, and indeed Mr Rajoy and his closest colleagues would surely
argue why it should, when nothing has so far been established or proven.

But as has been seen time and again in political scandals, once the finger has been pointed it is
hard for the tarnished politician to get himself out from under the problem. So in the interim
what Spain is almost certainly heading towards is a period of weak government, and this is just
what the country cannot afford given the serious economic issues still to be addressed.

And if the allegations should prove to be well founded, then this will only subtract even more
from the diminished credibility the country has after doubt was first cast over the bank loss
numbers, and then over the true size of deficits and government debt. In a country where the
informal economy amounts to more than 25% of GDP, discovering the people in power and
have responsibility for addressing the issue themselves form part of the problem will hardly be
good news for markets.

So just when the Eurozone crisis seemed to have been given the all clear until after the
German elections events have taken a fresh, and unexpected turn. The present government
now lacks credibility both with its own citizens and with the international community. While
only a week ago a bailout application seemed completely off the cards now it may well turn
out to be on them again. This explains the new risk positioning, the fall in the IBEX 35 and the
rise in the 10 year bond spread. In the days to come the Spanish government will undoubtedly
face growing pressure from the Troika to request aid, at which point a technocrat lead
government in the style of Mario Monte could be imposed. Equally the government will try to
resist these pressures with the result that a tug-of-war will ensue.

Most likely, given the momentum that the “risk on” movement has gained in recent weeks,
markets will eventually shrug off this latest bout of turbulence from Southern Europe as simple
background noise, but these events should serve as a reminder that nothing yet has been
resolved in Europe, and once global sentiment does shift decisively then all the old wounds
which continue to fester will simply be reopened.