There is a sharp rally in euro-denominated risk assets and some of you wonder if it is warranted and should it be chased. I am an analyst by vocation, so I try to look at things from a longer-term perspective: Did the successful bond auction in Portugal solve the euro crisis, and why should investors in emerging markets care?
Well, the several band-aid solutions in Europe have not actually addressed the root of the problem. First, there was the Greek bailout, next it was the Irish, and now we are finalizing the one for Portugal. You cannot call a bond auction successful if the banks that are participating in it have the assurances of the European Central Bank (ECB) that it will take the Portuguese bonds off their hands. Private institutions that are willing to put their capital at risk will have to step in to determine the market value of Portuguese government bonds, which will probably be lower without the ECB intervention.
But Greece, Ireland and Portugal are small countries. The true test for the euro will come if this spills over in Spain, which has a GDP of $1.374 trillion, twice the size of the three combined. Spain also has 20% unemployment and deflationary shock from austerity measures. Spanish bond yields have been going up — the 10-year government bond yield was at 4% in October, while now it sands at 5.35%. The spread to the relevant German bunds has been steadily increasing all year from 65 basis points last April to 235 at last count. We have had some improvement in the Portugal “news,” but I view it as temporary.
This is just temporary because the fundamental disconnect between fiscal and monetary policy in Europe is still there, where the various economies have diverging policy needs.
The Bundesbank would have probably been tightening interest rates in Germany by now due to their excellent economic performance and an accelerating economy, but there is no potent Bundesbank to speak of — for the time being.
The market has forced bond investors to swap government bonds from the periphery of Europe for German bunds, which results in extra easing of German monetary conditions in addition to the low ECB short-term rate of 1%. It is possible to see an inflation problem in Germany and an asset bubble in the not too distant future in addition to deflation in Spain.
Investment Implications for Emerging Markets
Investors in emerging markets should care about this situation, especially considering that the Greek drama in the first part of 2010 caused quite a correction. An eventual dissolution of the euro, which may be several years away, cannot be ruled out. Such an event has the potential for a financial crisis that rivals 2008.
The latest band-aid solution will stop the slide in European periphery bonds and the currency only temporarily for the above mentioned reasons. This makes Spanish government credit default swaps a great value at present levels for the few that can buy them. I had suggested a pair trade in Banco Santander Chile (NYSE: SAN) and Santander (NYSE: STD) on July 9, 2010. That meant to go long SAN and short STD — and the ratio went from 6 to 10 in the mean time, before pulling back to the current 7.72 level.
This is probably a good time to put the same trade on again. There is nothing fundamentally wrong with Chile, while Spain is in trouble. SAN may be a division of STD, but it is locally funded and shielded from the problems of the parent via a separate corporate structure. This is one way to go long “the good” part of Santander while hedging away “the bad.”
For those that can practice short-term timing, I am of the opinion that the sharp short-covering rally in STD is likely to fizzle out and the stock will likely make fresh lows in 2011. It is difficult to pinpoint the exact level where that will happen ahead of time, but any renewed weakness in the Spanish government bonds, rising spreads to bunds and a rally in the sovereign CDS contracts should give you the hint. Many European financials are swamped with problematic peripheral sovereign euro debt, which has not been properly marked down. Those are stocks to avoid in the present environment as it means big losses when the shakeout finally takes place.
When I wrote “The Euro Is in Trouble” on March 12, 2009, there was no euro crisis to speak of (it took a serious effort to explain it in the 800 words or so I had been given to work with). Then, when it became clear to me that the drama was about to unfold, I wrote “Why I’m Bullish on the Dollar” on Dec. 30, 2009. As of now, I see no comprehensive euro solution yet.
To fix the fundamental disconnect between fiscal and monetary policy, weaker courtiers have to surrender sovereignty to the stronger ones and synchronize what otherwise are far-from-harmonious tax policies. This is not something that can happen overnight or in a year’s time. The euro is likely going to go lower as this friction intensifies making my long-term EUR:USD target set in 2009 completely realistic — I think it’s heading to one.