Spain – One of the Weakest Links in Europe
(June 29, 2006)
Dear Subscribers and Readers,
As long-time subscribers may know, one of the geographical areas I am not very “fond of” in the longer-term is the countries of Western Europe – specifically in the Euro Zone which encompasses the countries of Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. There are many reasons why I am not optimistic about future economic growth in the Euro zone, and I will get right to the point since I also want to spend sometime in this commentary to discuss the current state of the U.S. stock market.
Chief among the reasons is the fact that growth in the Euro Zone has continuously disappointed over the last several years. This is best illustrated by the following November 2005 chart courtesy of GaveKal and CSFB – showing initial ECB growth projections for the last several years vs. actual growth:
In recent months, we have been again been getting ramblings of higher-than-expected GDP growth coming out of the Euro zone. Okay – an estimate of 2.2% real GDP growth (what the OECD is expecting) for 2006 is still relatively low compared to both the U.S. and Japan, but as shown on the above chart, a 2.2% GDP growth would represent the highest growth the Euro zone has experienced over the last several years. That being said, this author seriously doubts that the Euro zone can achieve a 2.2% real GDP growth figure for this year, given the following:
- As mentioned above, the historical tendency for the Euro zone to disappoint official growth forecasters over the last several years. The trouble with many of the models the “experts” employ is that these models contain a mean-reversion factor – a factor which is devised based on real GDP growth in the Euro zone throughout the late 1980s and 1990s. In today's globalized world and in a world where the general population of most of Europe is quickly aging, many European countries can no longer achieve the same productivity gains they had in the 1980s and 1990s – and they certainly cannot compete with the likes of China or India.
- Part of the 2.2% GDP growth estimate came from the fact that many business confidence indicators have been on a tear recently – none more so than the German IFO Index. For the last ten years, the German IFO Index has been a greater predictor of German GDP growth – except for the first quarter of this year – when it was foretelling a growth rate of 6% in the coming quarters. The main reason for this ridiculous number is mostly due to the promise of political and economic reforms since the last German election. While businessmen may eventually be correct in their optimism, it is difficult to translate long-term political and economic reforms into outsized economic growth in the coming few quarters. In other words, business leaders were answering a different question than what the survey was asking. Because of this, the German IFO Index will have to be rejected as a useful economic leading indicator going forward.
- The insistence of the German government to go ahead with a 3% VAT increase in January 2007 to reduce the government budget's deficit. The last time a government in a developed country tried to do this (implement a significant consumption tax), it absolutely killed the economy. The culprit? None other than Japan in late 1996. More importantly (and ominously for Germany and the Euro zone), the government is doing this in the face of declining disposable income in the country, while Japan actually experienced a real 5% growth in disposable income in 1996.
- According to Lombard Street, fully 39% of economic growth in the Euro zone came from Spain in the period 2003 to 2005. As I will mention below, the recent economic growth in Spain has been mainly come from the massive monetary stimulus from low interest rates as well as an “Anglo-Saxon” type housing boom. The Spanish current account deficit is expected to hit 8.9% of GDP this year and 9.8% in 2007. None of this is sustainable – and once the Spanish economy collapses, a significant part of the economic engine for the Euro zone will have disappeared.
- And finally, the insistence of the European Central Bank to keep on hiking without solid evidence of out-of-control inflation, against the advice of the OECD.
Based on these reasons, there is a good chance that economic growth in the Euro zone will continue to disappoint going forward – especially since the U.S. economy has shown solid signs of slowing down. Therefore, it is very difficult for the author to see the ECB hiking its overnight rates much further than 3% going forward (it is currently projected to hit 3.25% by the end of this year). Of course, stranger things have happened, especially as short rates in Western Europe have shown a tendency to be usually higher than nominal GDP growth for the last 20 years.
So Henry, where does the concept of “the weakest link” come into play?
Interestingly, one reason why Spain has been booming so relentlessly over the last several years is the fact that inflation (HICP) has been lower than overnight rates in the Euro zone since the end of 2002. Below is a chart courtesy of the IMF showing the major economic indicators of Spain from 2001 to 2005. Note that the HICP, the GDP deflator, as well as wage growth has been higher than the overnight rate set by the ECB since the end of 2002:
In other words, borrowing in Spain (and other parts of the Euro zone) and investing in Spain has been a no-brainer for the last few years. Given that the country is also home to a significant amount of prime coastal real estate, an “Anglo-Saxon” type real estate boom inevitably developed – which in turn drove consumer consumption, leading to higher income and wages and which in turn led to a further rise in housing prices. In other words, the recent Australia, British, and U.S. housing bubbles are definitely not unique. If there was a prize for having the biggest housing bubble in the free world, then Spain would definitely be up there for the running. The following chart courtesy of the IMF shows the rise in real housing prices in Spain and other developed countries from 1995 to 2004:
So given the huge “housing inflation” that was being created in Spain, why didn't the European Central Bank put a stop to it sooner? In this author's mind, there is no doubt that the current rate hike campaign is too “little, too late” for Spain – as any popping of the housing bubble should cause a hard landing in the Spanish economy. Part of the answer lies in the fact that both France and Germany had been experiencing sub-par growth for the last several years, and the ECB makes monetary policy for the Euro zone's weakest countries, not the strongest ones. As long as the Spanish economy was booming, no one really cared how lax economy policy had been.
Henry, what makes you think that the housing bubble will surely pop in the next 6 to 12 months? And what makes you think that the popping of the housing bubble will mean a hard landing for Spain? First of all, there is now tremendous overvaluation in the Spanish housing markets – as exemplified by the parabolic rise in housing prices (see above chart) over the last ten years and as exemplified by the following table (again courtesy of the IMF) summarizing the various empirical works on Spanish housing prices:
Second – and probably most importantly in the short-run – the interest rate on residential mortgage payments is for the most part tied to a floating exchange rate. The interest rate of the typical Spanish residential mortgage loan is tied to the Euribor (plus some spread) – which is in turn directly tied to the overnight rate as set by the European Central Bank. In other words, the bears who have been criticizing the folks taking adjustable-rate mortgages here in the U.S. in recent years should focus their criticisms on the Spanish homeowners instead:
While real estate wealth “only” makes up 30% of all households' wealth in the U.S., this is not the case in Spain – as fully 80% of household wealth is tied up in real estate. Therefore, a slowdown in housing price appreciation (or God forbid, a drop) will have a much more significant impact in Spain than countries that have experienced a similar housing bubble, such as Great Britain, Australia, and the U.S. in recent years.
Given that the ECB has a policy of setting economic policy for the weakest link (economy), there is good reason to believe that the ECB will again be cutting rates once the Spanish housing bubble pops. And given continuing deteriorating demographics, the lack of global competitiveness, and the implementation of a German VAT, it is difficult to see the European Central Bank overnight rate rising any further in 2007. In fact, one can argue that the economic situation (in terms of demographics and lack of dominance in the financial and technology industries) in the Euro zone today is very similar to that of Japan's. If Japan is keeping its overnight rates at near zero for the rest of this decade, then there is good reason to expect that the ECB will also put a lid on its overnight rate for the foreseeable future as well.
As for the U.S. stock market, I will write more about it (on our discussion forum) after the Fed meeting today. We all know that the 25-basis point hike is already baked in. The question now is: Will the Fed raise 50 basis points, and if not, will they raise one more time in the August 8th meeting? Clearly, no one has the answers (not even Ben Bernanke himself), but it is surely interesting to see the “herd of economists” now calling for a 6% Fed Funds rate when 10 months ago, they were all guessing the Fed to stop in the wake of Hurricanes Katrina and Rita. As for this author, I am retaining my somewhat “dovish” stance, as I believe the Fed will ultimately stop at 5.25% or 5.5% at the most. As I have mentioned before, the structural story of Chinese and Indian-induced deflation remains valid. Moreover, as I have outlined before, spare oil production capacity is expected to rise significantly over the next 6 to 12 months – and should serve to put a lid on oil prices going forward. And finally, the Chinese importation of copper actually declined 60% on a year-over-year basis in May. A further decline in copper prices is now inevitable.
And finally, I am going to leave our readers the following monthly chart showing the total NASDAQ short interest vs. the value of the NASDAQ Composite from September 15, 1999 to June 15, 2006. Please read the text below and make up your own minds – but unless we are going to have another NASDAQ bust in the next couple of years (which is not very likely), this author is going to interpret the following development as short to intermediate-term bullish:
Henry K. To, CFA