Random Shots - Smoke Screens

First off obviously; Spain and the country's bailout which was announced yesterday. Alpha.Sources is amazed that it has not happened before really. As we have seen so often before when Europe is on the brink of disaster this time with a Greek exit looming and Spanish banks in tatters, a response has been cooked up in the fudge factory. 

Spain asked euro region governments for a bailout worth as much as 100 billion euros ($125 billion) to rescue its banking system as the country became the biggest euro economy so far to seek international aid.“The Spanish government declares its intention of seeking European financing for the recapitalization of the Spanish banks that need it,” Spanish Economy Minister Luis de Guindos told reporters in Madrid today. A statement by euro region finance ministers said the loan amount will “cover estimated capital requirements with an additional safety margin.”

With Greece the immediate danger only a couple of weeks ago, the failure by Bankia seems to suddenly have alerted the eurostriches to the vortex of capital destruction in the Spanish banking system and the inevitable bailout got the fast track rubber stamp. 

Two points are interesting to focus on initially here. 

Firstly, the headline number of €125 billion is big, really big. Only a couple of weeks ago we were hearing numbers of a €20 to €30 billion euros for Spanish banks and this underscores just how expensive this may turn out to be. Consequently, we don't really believe that this is going to be the final number now do we?

Looking at mortgages alone, the accumulation of negative equity by households may rack up a total tally of more than €250 billion euros and this does not include property developer loans. Spain decided early on to attempt to let time be a healer and assumed that losses could be taken over time without the market catching on. This weekend's events show us that this is not possible and I think that the final number will have German and IMF accountants working over time to figure out just exactly where the money is going to come from. A corollary to this point is the also that the EU badly needs to sort out the firepower for the EFSF and the ESM since the original structure simply won't have to capital to sort out Spain and cannot, in its current form, simply access the market for more.

Secondly, the battle of numbers mentioned above seem initially to have taken the backseat to the discussion of whether in fact Spain has gotten a bailout or simply a very cheap loan by a willing lender.  Finance minister Luis de Guindos plays the part well. 

“The financial support will be directed to the FROB [Spain's Fund for Orderly Bank Restructuring] which will inject it in the financial entities that need it,” said finance minister Luís de Guindos in a press conference this afternoon. “It is a loan with very favorable terms, much more favorable than the market’s. In no way is this a bailout.

Obviously, this is nonsense but we must understand that this is a critical discourse to push for Spain. Every single country that has so far received an EU/IMF bailout is dead in the water either now effectively under permanent stewardship of a troika or simply in some form of default. In this light, Spain has a distinct interest in pushing the story that this is not a bailout, but my feeling is that this weekend may have marked the last time for a long while that the Spanish sovereign has accessed the market on normal market conditions. 

In this sense, yours truly certainly agrees with Edward. If it walks like one and quacks like one and all that. 

“Of course it’s a bailout. What else would you call it? If you can’t finance your debt, and you have to ask someone else to finance it, it’s a bailout. But everybody who’s taken a bailout is dead, and Rajoy doesn’t want to be dead."

Still, while Edward may have the right point here there is a finer point to be made. The higher the EU/IMF bailout efforts reaches up through the pecking order in the peripheral economies the weaker Germany's and the EU's hand becomes. You can just imagine the discussion about conditionality with Spain withRajoy et al simply pointing out the obvious in terms of a complete meltdown of the euro zone economy in the even of an un-managed unravelling of the Spanish banking system. 

The smoke screens will be blown thick and fast from Madrid, but the initial spin is very easy to predict. Spain's problems, we will be told, reside in its banks and therefore the government needs less supervision relative to Greece where the government is the culprit. As Lisa Abend puts it (article linked above), 

Any European and IMF oversight–the latter will not be contributing funds but will be involved in monitoring their use–will be restricted to the financial sector, not the Spanish macroeconomic system as a whole.

This is absolute tripe of course.  One of the main lessons of this crisis is that in the case of a highly risky stock of private debt in the private (banking) sector it is only a matter of time before this liability must be assumed by the sovereign (Ireland is an example here, but Australia and Denmark exhibit similar characteristics).  One would expect Spain to continue playing this implicit card of systemic importance in order to starve off the stigma of bailout. Naturally, this is grossly unfair for Greece which is being submitted to chemotherapy even as there is a 50/50 chance that the treatment itself will kill the patient. This is is especially the case if the ECB/EU end up chucking the country out through a stop of the ECB liquidity life line. 

Reality Creeping up on Japan

Of the deluge of news the past couple of weeks, what caught Alpha.Sources' attention was how the Bank of Japan pushed back against increasing government cries for more monetisation. 

BOJ Deputy Governor Hirohide Yamaguchi said the central bank will not rule out further easing if risks in Europe materialize and exert strong downward pressure on Japan's economy. But he signaled that Japan will likely achieve the BOJ's 1 percent inflation target without further monetary easing steps, saying the bank's stimulus measures in February and April have heightened the chance the economy will resume a recovery.

A sign of the times perhaps that central banks are starting to feel the pressure from the very guardians of their assumed independence to do more, and to do it more aggressively. As always it will be difficult for central banks to do much since ultimately that would involve biting the very hand that feeds them.

Still, it was refreshing to hear the governor Shirakawa rise above the relationship with the ministry of finance to link Japan's chronic deflation problem to the country's ageing population. If only leaders and economists in Europe would listen to this rather than the consensus that has now emerged that a euro breakup and exit is now the inevitable outcome.

Another interesting structural force which seems to be at play in Japan is the fact that the trade balance may never swing back into surplus due to the dependence on energy imports. Primarily LNG imports tied to the oil price on long term contracts. Alliance Bernstein estimates in a recent note that of the Y1 trillion increase in imports since April 2010, about Y700 billion has come from LNG imports which has replaced the country's idle nuclear capacity. As such idleness is likely to be structural so will the persistent trade deficit likely become structural. 

We should remember however that Japan still runs a substantial current account surplus as a result of a positive income balance derived from the world's largest positive net foreign asset position. Still, the current account surplus is shrinking fast coming in at only 2% of GDP in 2011 which is the lowest in 12 years. As suhc, despite Mr Shirakawa believing that the BOJ has done enough, the onus on the central bank rises to start monitising government debt less Japan wants to peddle bonds to foreigners in which case reality would instantly catch up the Japan's government finances. 

Deflation Risks Re-Emerge with a Venegance, but Central Banks Prefer Stagflation

Moving on to the market, my dear reader we are at it again. Europe is once again on the brink of disaster with a Greek exit looming and Spain all but certain to seek the inevitable bailout. As so often before, starting up the fudge factory seems to be the most likely outcome , but could this time be different? 

A number of heavy weight columnists have recently (yet again) proclaimed that the end of the world is nigh. Most devastatingly was of course Raoul Pal's End Game presentation which gives investors a mere 6 month to protect themselves before heading for the bunker. 

In addition, Soc Gen's Albert Edwards also recently touched on the growing and most disconcerting disconnect between global stock markets and all time low (and even zero or negative) bond yields in the developed world. 

As 30y German Bund yields slide below 2% and rapidly converge towards Japanese rates, we have a taster of what is to come in the US and UK in the months ahead. We still see US 10y yields even now making new all-time lows falling below 1% as hard landings occur in China and the US. The secular equity valuation bear market began in 2000 and renewed global recession will be the trigger to catalyse the third and hopefully final, gut-wrenching phase of valuation de-rating. Expect the S&P500 to decline decisively below its March 2009, 666 intra-day low. All hope will be crushed.

And in his latest flash comment, Greed and Fear (Chris Wood) also alerts investors to the threat of deflation. 

The consensus monkeys have been proved wrong yet again. A mere three months after talkingheads on the sell side were doing their usual annual first quarter ritual of proclaiming the endof the “secular” bull market in US treasury bonds, the ten-year bond yield made a new all-timelow of 1.45% on Friday. 

(...)

It continues to amaze GREED & fear how most analysts in the West continue to underestimate the deflationary structural forces at play and are always trying to pick the peak of the bond bull market (in price terms) and the commencement of inflation. Still the main reason GREED & fear has so far avoided succumbing to this temptation is that GREED & fear has been observing Japan for more than 20 years. And for GREED & fear, and for anyone else who has been watching Japan for a similar period, the market action in the West since the global financial crisis hit in the summer of 2008 does not surprise. Rather it remains eerily familiar.

Alpha Sources is concerned, as ever, that a wash-out is coming and certainly remains in the structural deflation camp in so far as goes global debt and growth dynamics writ large. It is also the contention here that it remains a widowmaking trade to call the end of the bull market in bonds, that would require much a much more sinster involvement of bond vigilantes from whatever hole they might appear.

However two points are worth noting.

Firstly, G&F's comparison with Japan may only be as good as it goes. While the blueprint is the same and there central banks have woved no to repeat the Japanese experience. The stated intention of central banks remain to print when it doubt. 

Nowhere is this clearer than with Bernanke. The Fed chairman has demonstrably stated his intention not to travel down Japan's road to deflation. Could it be that this commitment in itself will lead us to an alternative outcome? As always, the proof will be in the actual effect of additional monetary and fiscal stimulus where I would note that in past periods of QE in the US, bond yields have increased! Then there is of course the BOE where Mervyn King and his council have been extremely aggressive in their efforts to combat perceived deflation risks. 

Secondly, on the scenario laid out by Albert Edwards,  one has to note that the stock market is essentially just a nominal price and nominal prices can be manipulated by authorities. While Edwards clearly believe that we are heading towards a situation where this is impossible, Alpha.Sources would be weary betting on a fallout in the S&P 500 to the 500s before the Fed's toolbox has been completely exhausted. Negtive interest rate on excess reserves as well as outright unsterilized purchases of financial assets are the likely next steps if things go south from here. 

But, as always, Edwards is on to something. As stock markets ran up in the aftermath of the ECB's LTRO yields stayed pinned to the floor. When and how aggressively would yields catch up to the stock market? Well, it seems now that we know the answer to this question; the market may just be about to catch up with falling bond yields even if the latter remains severly oversold in the short run. 

We are now in a situation where developed government bond markets still considered safe are pricing in a calamity, but it is important for investors to understand that such apparent grave "expectations" are amplified by the very nature of post crisis financial markets where government bond markets across the European periphery are considered nothing but a very risky equity investment (due to the implied subordination to an ever growing size of the institutional (ECB and IMF) sector involvement in this market). 

In this sense, there is a considerable fundamental mispricing mechanism being operated at the current juncture where normal discounted cash flow valuation analysis cannot be used to explain why anyone would want to pile into government bonds. Or put differently, there are many reasons to hold government bonds and the discounted return from holding to maturity is not necessarily one of them. Liquidity and preservation of the face value of capital are much more important in the current climate even to such an extent that investors are willing to pay a premium for the return of their capital at a later date (negative interest rates). 

In the US for example, it is not clear to Alpha.Sources for example that inflation expectations in the US are pricing in stagflation rather than deflation. This makes sense if we believe in Bernanke's commitment. Of two evils, the Fed appears to prefer stagflation over deflation and it will make sure that faced with such a binary menu, the former is what materialises. 

In the short run, the stark drop in US payrolls may give direction with equities likely to correct downwards towards what the bond market has been telling us for a while rather than the other way around. But ultimately and while Alpha.Sources is weary of the threat of deflation, it is important to show significant respect the playbooks of central banks. Evidence has taught us not to underestimate the ruthlessness by which central bankers are ready to provide inflationary stimulus and as such Alpha.Sources will be hesitant to claim, unlike in the case of Spanish politicians, that they are blowing smoke screens. 

The Denial on Housing in Spain

I am sure many of my readers will have caught this Bloomberg piece earlier this week, but if you haven't it is a brillian piece of journalism by Bloomberg reporters Sharon Smyth, Neil Callanan and Dara Doyle. The story takes us to Spain and Ireland and the former's denial with regards its housing market. 

Quote Bloomberg

In the stages of death of a real estate boom, Spain is still in denial. In Ireland, they’re moving toward acceptance. The first auction of one of 2,000 unfinished housing estates takes place tomorrow at the Shelbourne Hotel in central Dublin, with sales expected to fetch cents on the euro, showing the Irish may be closer to the end than the beginning.

“Ireland faced up to its problems faster than others and we expect growth there rather soon,” said Cinzia Alcidi, an analyst at the Centre for European Policy Studies in Brussels. “In Spain, there was kind of a denial of the scale of the problem and it may be faced with many years of significant challenges before full recovery takes place.”

Spain, Europe’s fifth-largest economy, is the current focus of attempts to contain the region’s sovereign debt crisis, as Prime Minister Mariano Rajoy struggles to quell speculation it will need a bailout. Developers are showing similar optimism. They continue to build even with 2 million homes vacant around the country, new airports that never saw a single flight being mothballed, and property appraisers and banks reporting values have fallen only about 22 percent, said Encinar, who estimates the real decline is probably at least twice that.

Another passage that was staggering to my mind was the comments by Miguel Angel Garcia Nieto, mayor of Avila (a town showcased in the article) that this is just an interim soft spot as a result of the crisis and that oversupply and overcapacity will eventually be absorbed. 

Quote Bloomberg

“When we approved the first urban plan back in 1998 there was an unprecedented demand for homes,” Nieto said in a telephone interview on April 19. “Yes, there is oversupply at the moment because of the financial crisis and everyone’s gone back home to live with their parents, but it’s not because there is lack of demand. When the economy gets back on track I am confident the supply will be absorbed.”

Hope as they say, springs eternal.

Vámonos - Voting with their feet in Spain?

As the proverbial line seems to be running out for Greece, I thought that I would look at a slightly longer, although no less important, issue in the context of Spain; more specifically the trend in net migration. While much of the focus on Spain's membership of the Eurozone has been (rightly) centered on the effect of interest rates that were too low, for too long another important aspect is the boom in immigration that followed at the turn of the 21st century.

Indeed, when we today speak of Japan (and Germany) as the oldest economies of the world Spain was, by 2000), destined to become just this but an impressive net migration rate from 2001 to 2007 managed to buck the trend; 

(click on pictures for better viewing)

The decline in net migration is naturally a by-product of the crisis especially as immigrants (and especially those who are more or less sans papiers) are in the front line when recession strikes.

(quote Time)

The wave of immigrants into Spain has been fast and furious. The nation's foreign-born population shot up from little more than 2% in 2000 to more than 12% in 2010. "The process was so quick and so intense that Spaniards and politicians had a hard time understanding what was happening," says Josep Oliver, an applied-economics professor in the Universidad Autónoma de Barcelona and one of the lead authors of the Yearbook of Immigration in Spain 2009.

Then came the credit crunch, with its mass layoffs, stagnant growth and fiscal austerity. More than a million migrants have lost their jobs, homes and small businesses in a boom-to-bust cycle not seen since the Great Depression in the U.S. To be sure, migrants around the world are feeling the pain of the recession. But Spain's massive and recent immigrant influx, compounded by economic restructuring beyond the construction industry, has taken a particularly high toll on foreigners, magnifying the crisis for the country as a whole.

With the unemployment rate almost surely on the wrong side of 20% you could be excused for arguing what exactly the problem is here. Surely with this kind of excess capacity in the labour market the last thing Spain needs is for the migrants to stay competing for already incredibly scarce jobs. Indeed, the Spanish government has tried to create incentives for unemployed migrants to leave in order to free up the mismatch between supply and demand for labour.

This approach however does not hold up to basic economic intuition even if it is an understandable move from a political point of view. First of all, there is likely to be a low value added skill bias in the kind of jobs migrants are taking. This is then an often misunderstood point in the context of western societies' attempt to cherry pick the brightest graduates and lure highly skilled foreign labour to the country with lucrative tax breaks. As such, low value added labour (relative to the average level of value added in the receiving country) can provide a crucial labour input to the labour market in the form of filling up vacancies that domestic labor seekers would otherwise shy away from.

Now, you might again protest that in a severe crisis and as desperation among job seekers kick in, the matching for vacancies become subject to a general process of trading down as people accept jobs they are not qualified for simply in order to make ends meet. This is undoubtedly true but this is also the difference between a win-win and lose-lose situation then.

Migrants are ultimately attracted by work opportunities and the sharp decline in migration rates in Spain can be seen as migrants voting with their feet. In this sense, net outward migration of relatively low value added labour only to let domestic workers compete for these same jobs is not a sign of virtue let alone a recovery. I would hold this to be one of the most important structural issues to look out even if the long run effect of an economic crisis on migration is difficult to predict. In addition, and this is evident in Eastern Europe, there may be a strong (and worrying) me too effect from foreign immigrants leaving as it migh even incite Spanish young people to contemplate leaving as well especially as the labour market continues to look dire.

Finally, the obvious question is whether Spain needs immigration? Indeed it does;

As such and strong immigration notwithstanding Spain is still ageing and, rapidly so! Note especially, the twin peaks of first the 20-39 age group in 2002/03 and then the 35-54 age group in 2011/2013. This is then the great tragedy of the peripheral economies in the Eurozone in the sense that whatever last ounce of demographically induced momentum they had will likely be completely erased by the demands for fiscal austerity and internal devaluation. And once this process has run its course (whatever that means) their population pyramids will be beyond repair.

Looking at age specific migration in Spain and considering that by definition migration occurs among the most mobile part of the population (i.e. the working age population), the trend has reversed. This is also why migration flows are an important input to the analysis of global population ageing even if immigration, in no country, would be able to completely nullify the wave of ageing (indeed in some economies such as China and Russia immigration will be almost impossible to achieve in sufficient scale to dent the force of ageing).

The influx of migrants to Spain in the age group 20-39 has consequently steadily declined in the past 4 years.

The article above by Time personifies the Spanish migrant in the form of 35-year-old Colombian construction worker Doney Ramírez who used to police one of the many, now idle, construction cranes in in and around the building sites of Madrid. You could then note that Spain certainly does not need Mr Ramírez anymore as the future of Spain is not built on construction of empty houses. Indeed I would agree, Spain now needs to export. But neglecting the importance of  Ramírez would be poor economics since quite possibly he could do a different job (if the economy could create one for him) and more importantly the fact that he is now more likely to leave than stay says a whole lot on the effect of ongoing deflation and deleveraging faced by Spain.