Fiscal Pain in Spain Turns Into Reality Show

by Bryan Perry | July 31, 2012 11:00 am

Despite all the bravado “can-do” language from leaders of the eurozone’s top economic powers last month in Brussels, it has become quite clear that once the party in the land of Belgian chocolate and beer was over, those same heads of state went home and essentially failed to act on any proposals or measures that sparked the rally earlier this month that suddenly has fizzled badly.

It’s a real shame that the European Central Bank (ECB), the International Monetary Fund (IMF) and the sovereign governments all sit back and dither, watching their region slide into a very avoidable recession. The head of global asset management at Goldman Sachs (NYSE:GS[1]) appeared on Bloomberg TV Wednesday morning to publicly exhort ECB President Mario Draghi to take bold action right away. But nobody in Europe is ready for the loss of fiscal and political sovereignty that lasting solutions like letting the euro devalue to stimulate exports would demand.

Some countries already are backtracking even on relatively unambitious measures to fix the single currency’s institutional framework agreed to at the last summit. Not surprisingly, it now seems that Europeans are losing enthusiasm for a currency that seems to bring only economic ruin to the south and intolerable bailout obligations to the north.

One can only describe the inaction by European policymakers as an abdication of duty. Even worse is that examples of successful economy restructuring are right in their backyard. Look at Estonia, Albania, Poland and Sweden, all of which took the 180-degree opposite strategy of the Keynesian model that has been the preferred bailout model of socialist-leaning PIIGS nations.

Their current strategy — printing trainloads of fiat currency while maintaining high taxes that are predicated on a massive economic rebound — has about as much chance of succeeding as a hapless tourist expecting to win big playing poker on a cruise ship.

The bond markets are flashing a big red flag that something radical needs to be done yesterday. Last week, the 10-year Spanish bond yield spiked to 7.6%, sending shivers through global credit markets and prompting a further flight to quality. Even more concerning is that Spain’s 5-year bond had a higher yield than the 10-year bond, implying that the current fiscal landscape there is unsustainable without significant bailout funds.

That’s the same inverted yield curve we saw with Greek debt, but there’s a difference. Greece’s economy is the size of Delaware. Spain’s economy is the fourth largest in the eurozone — as in “too big to fail.” Apparently, this most recent development got the ECB’s attention. Comments from Draghi about how he’ll do whatever it takes to save the euro are providing a relief rally.

Moody’s (NYSE:MCO[2]) went as far as to put Germany’s credit rating on watch for a potential downgrade, citing the deteriorating conditions in Greece and Spain and the drag it’ll have on Germany’s balance sheet. No doubt, it’s crunch time in Europe.

As for current events in our high-yield world, there’s a riptide of capital flowing aggressively into Cash Machine assets. With traditional fixed assets paying 0% to 2%, capital flows into the sectors we are over-weighted in are nothing short of robust. It’s as if investors are resigned to the fact that the U.S. economy can’t decouple from Europe’s problems. Their issues slow our economy, resulting in multiple contraction for growth equities. That leaves high-yield assets as the gold standard for savvy investors.

The flight to safer trades has the 10-year Treasury Note yield down to 1.4% and the 30-year Treasury Bond yield at a record low of 2.49%. Who in their right mind would buy 30 years of risk for a 2.49% return, especially in a currency that is in a protracted downtrend?

If the chart of the U.S. dollar below is any kind of predictor, then the current rally in the greenback is about to stall out and a further deterioration of the world’s reserve currency will resume. Makes sense with a government-debt-to-GDP ratio of 100% and a national deficit of $16 trillion in a contracting economy.

Cash Machine Weekly Update – July 26, 2012

I wish I could put some lipstick on this backdrop, but as we all watch the political world turn, it’s beyond frustrating to see the level of ineptitude being demonstrated at the highest level of government in addressing these very serious structural issues.

If the Fed does launch their last salvo of quantitative easing as suggested in a recent Wall Street Journal article, the official mouthpiece of the Fed, then we will get another selloff in the dollar and a “risk-on” rally of sorts for equities, but this strategy is not a long-term solution in my view and only invites bigger problems to contend with in 2013.

With that said, the market only seems to care about the moment at hand, and not the long-term ramifications of misguided fiscal policy.

I won’t fight the tape, and a global round of coordinated central bank stimulus could take the S&P 500 to new 52-week highs. As crazy as that might sound, that’s what the market is in love with.

  1. GS:
  2. MCO:

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