Not long ago, investors were worrying about the impact on the US housing market of the Fed winding down its quantitative easing programme, and what effect this might have on the global credit market. During the month of April, however, long idling but persistent rumblings regarding sovereign credit concerns around peripheral EU countries quickly grew louder, as a different link turned out to be the weakest in the global credit market chain. In the ensuing months, the cost of capital rapidly reset higher for European countries perceived to face the weakest combined debt/deficit/economic pictures, most prominently Greece, Portugal, and Spain. Based on market action, it appears that there are also some lingering concerns about Ireland, Italy, and the UK.
It is somewhat of a chicken or egg argument about whether some of these countries potentially faced solvency issues that caused the debt markets to react so negatively or vice versa. What we find undeniable is that a rapid reset higher in the cost of credit for already troubled countries increased the odds of a bad outcome for any particular country. This situation closely mirrors what happened in the US with its most financially troubled households. When the cost of (and access to) mortgage and credit card debt quickly reset in adverse fashion, the already high odds of default jumped overnight.
Also similar to the recent financial crisis that originated in the US, potential solvency issues tend to create liquidity problems for a very simple reason. The question credit market participants ask themselves is why extend or increase lending to now questionable credits--at such low rates, typically below 5%--if there is any question whether your principal will be returned in full? Liquidity and solvency questions lead directly to contagion questions and the potential for a domino effect. If Greece were to default, who owns that debt and who would take a large hit? Clearly, Greek banks would be in terrible shape as they are large owners of home country sovereign debt. Who owns Greek bank debt and is a large counterparty to these institutions? As Greece is small enough to be relatively immaterial to the rest of Europe in financial terms, its failure to repay its sovereign debt in full need not be catastrophic, although certainly a few banks would find themselves needing to raise additional capital. A similar argument could well be made for Portugal.
In our view, the most important domino in this series is Spain. This country admittedly has a much lower debt/GDP starting point than its more troubled peers, but its private debt/GDP is quite large and current deficits are enormous, as are unemployment and its recent housing bubble. In nominal terms, Spain is a much larger economy than Greece or Portugal, resulting in a larger total stock of sovereign debt, approaching EUR 500 billion. It is also home to two of the 30 largest banks in the world in Santander and BBVA, which are presumably quite interconnected with other large financial institutions throughout the world. Further clouding the issue, while most banks have recently self-disclosed their exposure to sovereign debt in Greece and a small minority have made disclosures regarding Portugal, very few have spelled out in detail their exposure to Spanish sovereign debt, much less all other corporate exposure to the country including bank, corporate, and real estate-backed debt. If Spain were to default, and this event blew a hole in the balance sheet of a bank domiciled in one of the other PIIGS countries, could that sovereign country credibly back its large banks, without pulling itself under?
Rather than risk the possibility of a nasty series of events as outlined above in a brazen test of market psychology, the EU has apparently decided to shield Greece from rollover risk via a large credit line. These below current market rate loans--which, notably, are drawn from fellow PIIGS countries as well as much stronger neighbours like Germany and France--are being provided in exchange for severe austerity measures aimed at crushing Greece's enormous budget deficit. A much larger scheme was also announced a couple of weeks ago that would offer similar loans to other troubled European countries if necessary, although we note that these plans are extremely short on detail (and thus credibility) at this point.
For an example of what large-scale austerity measures might lead to, let's look at Ireland, where such measures were self-imposed not long after the initial wave of financial panic a couple years back. The picture is not pretty, even though Ireland's populace seems much more adept at tightening its belt than what we've seen so far from Greece. GDP declined by double digits from the peak and the country currently faces deflation, even as the global economy resumed growth in the interim. Granted, Ireland experienced an enormous housing bubble that inflicted severe damage on the economy and the country's banks, but Spain also experienced a housing bubble and already sits at 20%-plus unemployment even as its own austerity measures only now begin in earnest. While there is no choice but to close a double-digit fiscal deficit when the markets refuse to fund it, austerity measures clearly don't solve the problem without provoking additional pain in terms of GDP and unemployment. Quite simply, sharply lower government spending and higher taxation combine to create a distinctly deflationary event.
One could argue whether the EU should have bailed out Greece to prevent the first domino from falling or that this is merely a game of kick the can that will ultimately fail--meaning resources would be better spent protecting larger countries with lower debt levels like Spain. One can also argue that the EU should let the markets determine the fate of various countries vis a vis their sovereign debt situations and that large financial institutions should instead be bailed out following any catastrophic losses on sovereign debt holdings. Those that argue against both seem completely callous to the risk of global depression that would result from widespread systemic failure of financial institutions and wipeout of associated savings.
Fortunately, it looks as though the EU is determined to protect against the risk of this severe outcome. While it has taken several meaningful steps in the right direction with its announced loan schemes and small-scale sterilised purchases of sovereign debt, it's our opinion that they need to complete the prescription by laying out all the necessary details and enforcement mechanisms surrounding the loan schemes. We're also of the opinion that large-scale quantitative easing with associated sovereign debt purchases might well be required to send a strong enough signal to the capital markets that the European Central Bank is determined to protect against a capital market meltdown as investors shove past each other for the exit and/or deflation resulting from widespread austerity measures imposed on already crippled European peripheral economies.
Until these two things happen, investors should exercise substantial caution with bank stocks domiciled in PIIGS countries. While these stocks look cheap relative to normalised earnings, past experience with Irish bank stocks provide a cautionary tale. Two European bank stocks that have sold off in sympathy with recent market turmoil, moving closer to our Consider Buying prices, are Barclays and HSBC. We think both merit close consideration if they tumble further during any market fits. Likewise, the big four US banks (JP Morgan, Bank of America, Citigroup, and Wells Fargo) look more and more attractive on a purely valuation basis in recent weeks as fears of counterparty exposure to European banks and uncertainty around regulation cast a pall over these names.
Do you own any of these banks? Are you considering switching or are you managing to stick to your fundamentals? Share your thoughts with us in the comments box below.
