Spain – It’s The Real Economy Stupid!

As foreseen in recent updates on Spain, the market for SGBs remains calm and spreads across the maturity horizon are tightening. Last week Spanish ten year yields fell below the 5% mark for the first time since March last year, while two year yields are now hugging the 2% threshold. During the week the Spanish debt agency sold 5.8 billion euros worth of bonds at yields which were significantly down over recent levels across all maturities.

For some this amounts to growing evidence that the worst of the Euro debt crisis is now behind us. We would warn that such conclusions are way too hasty. What we in fact have is a hiatus in the crisis, a kind of armed truce, whereby investors take Mario Draghi at his word and assume he is giving implicit backing to peripheral bonds such that yields will not be allowed to spike again. This makes the extra yield on offer look extremely attractive given the lowering of risk, and the absence of easy attractive alternatives.

The calm is likely to now extend through the German elections in the autumn, since during this period very little of note is likely to be allowed to happen. There is, to be sure, a certain degree of uncertainty attached to the outcome of the Italian elections – as we have been highlighting – but the risks here are likely to be manageable in the very short term, even if we may see some attempt at brinksmanship in the light of Angela Merkel’s evident vulnerability. What will happen after the German vote is another matter entirely, and someone – whether German voters or investors who believe the politicians promises – is going to be disappointed.

So Spain’s government will be able to finance itself, and most probably won’t even come under pressure to go for a bailout, the IBEX35 will hold its gains, and the banks will continued to be reasonably well capitalized throughout 2013. It’s what happens next which presents the problem.

Despite progress made in the financial economy, conditions in the real economy continue to deteriorate, and we don’t see any end to this process in sight. True significant gains in exports have been made, and the current account balance has moved faster than expected towards positive territory, but this alone is going to be far from sufficient to send the economy back into growth mode. Domestic demand continues to decline, and all the relaxation on deficit targets means there is much more fiscal tightening to come.

Despite all the reforms so far enacted Spain remains a long way from being fully economically competitive. Exports have improved, but there is very little investment in new capacity, so it is difficult to see how the country can continue to raise export output as it has been doing. In addition the rebound in Euro value will not help the process.

Meanwhile house prices continue to fall, sales remain very low, and unemployment is now near 27% and still on an upward path. With young people and migrants leaving in search of work abroad at an ever faster rate, it is hard not to reach the conclusion that some things are getting worse faster than others are getting fixed, which means the crisis is set to run for some considerable time still.

Thus the main risk, as in other periphery countries is not in the bond markets, it is at the ballot box, or in street protest, as the population wearies of reforms which bear no fruit in terms of employment or living standards. The clock is ticking away, while Europe’s leaders give every indication of having, yet one more time, fallen asleep at the wheel.