By Lior Alkalay
Not too long ago, I mentioned that the markets had been maintaining an overall bullish momentum on the premise and promise of expectations of more central banks’ easing, hopefully coming long before the markets could really deteriorate. And since then, we have seen a Spanish bailout, an ECB rate cut (to a record low), the extension of the Fed’s Operation Twist, more QE from the BoE, a Chinese rate cut, etc..
Despite these events, which in a perfect world would be positive market movers, sentiment has continued to deteriorate and prices pushed lower with investors all but shrugging off the various attempts to stimulate the economy.
The question is why?
Last year at around the same time, we were in the midst of another bull rally with Gold prices soaring, the S&P500 breaking resistance levels and the Euro recovering. But this time, something is different and the difference is the cognizance by market participants –myself included –that a deep 2008-style banking consolidation needs to happen in Europe before a real recovery can take place.
Don’t get me wrong; I still believe that over the long-term, say the next decade, U.S. big caps alongside European and Asian big caps will provide healthy returns. But it seems there is another storm ahead of us that we have to get through before that big long-term cycle can take place.
The part of the equation which has changed is the understanding that the Spanish crisis is actually part and parcel of the European banking crisis that can only be solved with a Lehman-style consolidation. While that could potentially drag risk assets sharply lower, and growth along with it, the good news is that this would also signal the final episode of the crisis in Europe.
Spain at the Eye of the Storm
Spanish banks have received a bailout commitment of €100 billion, with €30 billion of that already transferred. If you recall, the markets’ euphoria over the deal was short-lived and there’s a very good reason why that was – namely, the Spanish housing market. In many respects, what is happening now with Spain’s banks is identical to what happened with Lehman Bros in 2008. Many Spanish banks are still holding losing mortgages on their balance sheet.
The potential loss to Spanish banks is drawn into sharp focus when you compare Spain’s housing boom to Ireland’s. While both housing markets rose sharply, gaining around 150% in the 7-year period from 1999 to 2006, the subsequent fall in Spanish housing prices was only half that of Ireland’s. Put another way, this means that Spain’s banks’ bad loans, estimated at around €146 billion, are grossly underestimated. In reality, the actual number should be significantly higher; worse, those too many foreclosed homes will weigh heavily on the market, pressing prices substantially lower.
With the Spanish private debt market nearly twice the €700 billion Spanish economy, delinquencies can be expected to be huge, with almost all of the European banking system exposed. Because the amount needed to recapitalize the Spanish banking system quickly keeps rising, this could be sufficient to deter policy makers from any other course of action, in favor of allowing a big Lehman-like collapse and a massive consolidation – big banks taking over small and profitable banks swallowing up unprofitable ones. Of course, this would also be followed by a wide consolidation in equity markets and inflation-linked assets like Gold, because when credit is crunched, inflation worries evaporate.
Gold is Exposed to Heavy Selling
For those seeking an active bearish strategy, Gold seems especially vulnerable given the dual effects of the U.S. Dollar’s strength and a collapse in inflation expectations. When analyzing the Gold trend during the Lehman collapse it is clear that the metal is exposed to heavy selling. Of course, once the consolidation is over the inflation expectations will return and with it investors’ appetite for Gold. Until then, though, with every new sign of further deterioration in Europe, investors are giving Gold the cold shoulder.