The pain in Spain

After a strong start for the year, global stock markets were treated to another round of volatility as the EU sovereign debt crisis again gripped the headlines in the past few weeks. Over the past two years, we repeatedly wrote about Greece, which has been at the epicenter of the EU debt drama (A Greek Tragedy, Sept. 12, 2011 and The Greek Drama Continues, Nov. 7, 2011). We also wrote about Italy (Too Big to Fail, Too Big to Save, Nov. 14, 2011), when its 10-year bond yield surged past the seven percent level late last year.

In the last few weeks, it was Spain that was thrust into the spotlight when it asked for bailout money for its banks. Last week, it was agreed by EU authorities that Spain will receive the much-needed $126-billion lifeline for its banks. Concerns that the Spanish bank bailout will only increase the tremendous debt burden of the Spanish government prompted Moody’s to downgrade Spain by three notches to Baa3, just one level above junk status.

Spain’s sovereign debt and banking problems add to the uncertainties following the Greek elections and the growing concern about Italy’s rising debt yields. These are signs that the EU sovereign debt crisis is deepening, which might bring further volatility to global equities.

The ‘IPIS’ Theory

Over 2 years ago, we wrote about the “IPIS” theory (The “IPIS” Theory, Feb. 22, 2010). Our theory stated that if one sees a cockroach, there are probably more cockroaches hiding within the vicinity and it is just a matter of time before these roaches also come out in the open. Back then, we said that the sovereign debt problem of Greece may not be a one-off situation and that other EU countries might also follow suit and eventually ask for bailouts. True enough, Portugal and Ireland followed the tragic trajectory of Greece, as they too have been forced to seek bailouts when their borrowing costs surged.

Currently, it is worrisome that the contagion has already spread to bigger countries like Italy and Spain, the 3rd and 4th biggest economies using the common currency. To put things in perspective, Italy’s economy is roughly 7x the size of the Greek economy, while Spain’s economy is approximately 5x that of Greece. The growing concern is that EU authorities will find it more difficult to bailout Italy or Spain because of the sheer size of their economies.

Greek bank runs

The Greeks just completed their much-anticipated elections yesterday and the final results would probably be known today. There is much anxiety as to whether the newly-formed government would be able to renegotiate its bailout program with EU leaders and deliver the necessary reforms to justify continued bailouts from EU authorities. As the specter of an EU exit hangs over Greece, deposit outflow among Greek banks has accelerated over the past week. Bank depositors are afraid that a win by the Syriza party will lead to a populist government. This can then trigger a Greek exit from the euro, thereby causing extraordinarily high inflation, massive currency devaluation and a huge shortage of goods. Because of these fears, Greek depositors have chosen to buy goods rather than maintain their deposits with the troubled Greek banks. This is eerily reminiscent of the Philippine experience in the early 1980s and in the 1997 Asian financial crisis – when fears of hyper inflation and massive currency devaluation caused depositor panic and bank runs.

European problem: No easy solution

Considering the current problematic situation of Europe, it seems that a single currency shared by countries which do not share the same fiscal discipline would not work. Because of the severity of the situation, more drastic solutions are being deliberated to diffuse the EU debt crisis:

Fiscal union: This calls for the closer fiscal integration of EU countries. A central institution will be formed in order to keep government revenues, spending and budget deficits of member countries in check.

Banking union: This will form an EU banking authority that will be in charge of tighter supervision and oversight of European banks.

Bank deposit guarantee: This will institute a common deposit insurance scheme for EU banks in order to restore the confidence in European banking system and stem the flight of deposits from European banks.

While these might help in alleviating the problems in Europe, there is still wide disagreement among EU leaders as to whether or not these initiatives should be undertaken. Further, the adoption of these solutions will take time to implement. Policy details would have to be carefully sorted out because these measures would have far-reaching implications.

In the meantime, a win in the Greek elections by the New Democracy, a party amenable to the bailout program, and the formation of a coalition government with Pasok, a pro-bailout party, can be the start of a difficult but long-lasting solution to the European crisis.

Philippine bonds – safe haven

The growing concern on Spain and Italy is reflected in the surge of their bond yields over the past few months. After settling in the five-percent territory in March 2012, the yields on Spain and Italy’s 10-year government debt again spiked, with Spain’s 10-year bond yield almost reaching seven percent last week. Note that the seven-percent threshold implies unsustainably high borrowing costs, as Greece, Portugal and Ireland were forced to seek bailouts when their 10-year bond yields breached seven percent. Since then, the yields on the 10-year euro-denominated bonds of Greece, Portugal and Ireland remain at unsustainably high levels. In contrast, the yield on the 10-year Philippine ROP is only at 3.2 percent. Below is a table showing the current 10-year bond yields:

Source: Bloomberg

The relatively low yield of the Philippine dollar-denominated bonds reflects the strong fiscal and economic position of our country. This can also be seen in the continued strength of the Philippine Peso (Strong US Dollar, Stronger Philippine Peso, June 11, 2012) and the resilience of the local stock market (Philippines: One of the few bright spots left, June 4, 2012).

Withstanding the pain

Based on the recent turn of events, it is apparent that the EU sovereign debt crisis is a complicated problem with far-reaching implications. The two-year debt contagion, which has also contaminated bigger EU countries like Spain and Italy, still does not have clear and lasting solutions. This brings about uncertainty among investors, which then translates to volatility in the stock market. Because volatility might continue in the short to mid-term, some equity traders and investors might be shaken out of their investment positions. We continue to remind our clients to follow an asset allocation strategy that they can be comfortable with amidst the shaky macroeconomic environment. Further, we advise them to focus on countries that have strong fundamentals and robust domestic consumption-driven economies, such as the Philippines.

Since the pain in the capital markets has recently been caused by Spain, we’ve titled our article today “The Pain in Spain.” We’d like to leave you with the song “The Rain in Spain” from one of our favorite Broadway musicals, “My Fair Lady.” Below are the last few lines of the song:

Now once again, where does it rain?

On the plain! On the plain!

And where’s that blasted plain?

In Spain! In Spain!

The rain in Spain stays mainly in the plain!

The rain in Spain stays mainly in the plain!

For further stock market research and to view our previous articles, please visit our online trading platform at www.wealthsec.com or call 634-5038. Our archived articles can also be viewed at www.philequity.net.