A few months back, in the wake of Spain’s World Cup triumph, my colleague Alan Rambaldini wrote a piece titled The Red Fury in which he wondered whether sporting triumph would translate into an economic boost for the Iberian nation of my birth. I remember reading Alan’s article with some trepidation. Not only was there scant empirical evidence as to the assumed positive economic effect of staging and/or winning sporting events, but I had a more interesting--albeit totally unscientific--statistic indicating that winning the World Cup might bring economic fortune unless one happens to win it by beating The Netherlands. Oops! Germany won the World Cup against the Dutch in 1974 and the then Federal Republic went on to experience a GDP contraction of 1.4% year-on-year in 1975, the first ever recession since the foundation of the country in 1949. Argentina beat the Netherlands to gain footballing glory in 1978. I have no proof, but I would not be surprised if the term “lost decade” was first coined in Spanish to refer to the Argentinian economic nightmare that was the 1980s.
The, let’s jokingly call it, “Oranje curse”, seems to be working its magic once more. As 2010 comes to a close the world financial markets are focused on Spain, and not for positive reasons. The Eurozone sovereign crisis limps on, and consensus has it that Spain is the battleground where the future of the European single currency will be decided. Greece, Ireland, and soon possibly also Portugal, are but small peripheral distractions; only useful as training exercise for the anticipated big battle. Spain is not in a good position to mount a credible defence on its own. Indeed, the big Iberian economy goes into 2011 in a rather feeble situation, with GDP expected to post a mild contraction in 2010 and still suffering from a construction bubble-burst hangover, an unemployment rate just a tad short of 20%, and a government budget deficit reduction strategy compromised by optimistic official macro assumptions and a bulky public and private debt rollover calendar. Unless one is into sob stories, this does not make for good reading.
A Spanish Problem Or a European Banking Problem?
Reduced to its very simplest expression one could argue that the main problem for Spain is not so much one of public debt (e.g. this remains some 20% below the EU’s debt/GDP average, even when computing the full effects of the upside trend) but one of private liabilities undermining sovereign solvency perceptions. International investors have deep-seated concerns about the exposure of Spanish banks, particularly regional savings institutions (i.e. Cajas), to bad loans made to the construction sector during the housing market bubble. The fact is that the Spanish banking system is by no means in the dire straits that the Irish one is. It is also a fact that the Spanish government has undertaken a deficit-cutting strategy encompassing some structural reforms. Alas, these facts mean little to a market in tunnel vision mode. And so, it does not look good for Spain.
The flip side of the argument is of course that this is also a significant problem for international investors as ultimate underwriters of Spanish debt. According to data from the Bank for International Settlements, foreign banks’ claims on Spanish debt, both private and public, accounted for $876.5 billion by end-2Q10, of which 75% was by European banks, with German banks exposed to the tune of $181.6 billion (20.7% of total), French banks to $162.4 billion (18.5%), UK banks to $110.8 billion (12.6%) and Dutch banks to $72.7 billion (8.3%). These data represent the lion’s share of foreign creditors’ exposure to Spain and provide a good geographical snapshot of who would be more at risk in case of systemic failure.
The corollary is that Spain is clearly a European banking problem, and those wanting to take positions with ETFs rationalised on Spain had better not overlook this Europe-wide dimension. In a previous article Sovereign Risk and ETFs: Do Your Index Homework, published on October 26, we gave an overview of the exposure to Eurozone peripheral government debt afforded by the most popular indices tracked by fixed income ETFs listed on European exchanges. But as mentioned, while sovereigns are the vehicle through which this crisis is being played out, they are not the root cause of the problem. Those wanting to hedge against or profit from an assumed negative outlook for Spain will also have to take care of the private debt side of the equation and account for European implications.
Taking Positions With ETFs
The obvious first port of call to roll out a short Spain strategy would be Spanish-centric equity ETFs such as the BBVA Accion Ibex 35 (BBVAI), Amundi MSCI Spain (CS1) or Lyxor Ibex 35 (LYXIB). All three follow equity indices with a substantial exposure to banking stocks, albeit on a diminishing trend by market capitalisation (e.g. the combined weight of Spanish banks represented in the Ibex 35 has gone down from 39.2% at the end of 2009 to 33% at the end of November 2010). Unsurprisingly, returns data for these ETFs are well into double-digit negatives as we write, with year-to-date figures showing a drop of 18%-19%. Over the same period, the Lyxor Ibex 35 Inverso (INVEX) (i.e. short) posted positive returns close to 9.2%.
However, unless one has a Spanish-centric investment portfolio, the buck does not stop with Spain. In keeping with the (perhaps too simplistic) analytical line so far followed in this piece, if anything, investors would need to take precautions with regards to exposure to the European banks in general. According to Morningstar data there are 23 sector-focused ETFs offering exposure to European financials with combined total net assets under management close to EUR 1.7 billion. Nine out of the 23 ETFs track indices offering exposure to European banks and account for 67% of net assets; eight track indices offering exposure to insurance stocks and account for 7% of assets; six track indices offering exposure to the whole financial sector (e.g. banks and insurance) and account for the remaining 27% of assets.
Not As Straightforward As It May Seem
But hang on, I hear you say: Wouldn’t a negative view on European banks necessarily weigh on the European economy as a whole? After all, widespread deleveraging and writing out of financial losses coupled with increased provisioning for future mishaps should restrict the flow of credit to economic agents. And what about the Euro? Well, yes. Systemic failure is actually a rather messy affair. And so, the relevant question is not whether Spain will be pushed off the cliff, but whether the parties bound to suffer most from its fall will let it happen. The jury is still out. Interestingly, the European Central Bank has already been hinting at a rethink of its bond purchasing strategy. If the ECB throws the regulations book out of the window and embraces QE with gusto, we would find ourselves in an altogether different ball game. And you know what happens with (market) herds in stampede, they have the ability to switch direction at the blink of an eye.
