GO
Loading...

How Will Pain in Spain Affect Markets?

Spain is now competing with Greece to be the euro zone country with most sway over the markets. How can you play this situation – other than taking all your cash out of the bank and hiding it under the mattress?

Spain
GlowImages | Getty Images
Spain

Forward-looking indicators for the economy, such as the composite PMI, suggest that Spain’s economy will struggle throughout 2012, with the slowdown accelerating in the second half of the year.

The possibility of Spain joining smaller peripheral euro zone countries like Ireland and Greece by tapping European rescue mechanisms by end of year seems to be rising. Morgan Stanley analysts put the chances of Spain tapping up the rest of Europe this year at 50 percent.

The fear in the markets is, at its roots, driven by the sheer size of Spain compared to existing bailout nations, and worries that Italy, which is even bigger, will follow it.

It’s important to note that Spain isn’t just Greece on a larger scale. The stability of the Spanish government with its absolute majority – particularly in comparison to the fractious situation in Athens – is one positive for the country. Another is its improved export performance and recent gains in productivity as labor market reforms take shape. Its links to faster-growing economies in Latin America could also help.

Unemployment figures could paint a worse picture than what is actually happening, as the size of Spain’s shadow economy is difficult to measure. Analysts at Morgan Stanley believe unemployment is lower than the 25 percent official figures suggest, and that the shadow economy might account for as much as one-fifth of the Spanish economy.

While the property market still has investors biting their knuckles in anticipation of another hefty fall in values, the construction bubble at least shows signs of petering out after construction investment fell off a cliff earlier in the crisis. This should make residential construction less of a drag on growth going forward.

The banking sector is another source of worry because of its close links to the property market. A recapitalization of the sector is on the agenda, from either the Spanish government or the ECB, which could need up to 100 billion euro ($123 billion), according to UBS analysts.

More consolidation in the banking sector is likely – but this should actually make the banking sector more profitable in the long term as it merges more of the regional Cajas, according to Morgan Stanley. Within the Spanish banking sector, BBVA is the preferred option of Alvaro Serrano, analyst at Morgan Stanley, who cited its strong business in Mexico.

The cost of borrowing for Spain shot up this week to uncomfortable levels, close to those at which other peripheral countries needed a bailout.

Yet Spanish bonds may not be as disastrous as they first appear. The Spanish bond market has become more domestic over the course of the crisis. Before the crisis began, foreign investors held just over half Spanish debt, but this has now fallen to around 40 percent. As domestic investors tend to hold on to their debt for longer, this could help keep a lid on the volatility bubbling in the bond market.

Spanish government bonds might be worth buying again if the bank recapitalization issue is dealt with, according to Elaine Lin, analyst at Morgan Stanley.

Whatever happens with Spain, analysts believe the euro will continue its fall against the pound, although it will be accelerated by continued uncertainty.

Guillermo Felices, head of European currency strategy at Barclays Capital, recommends buying a 6m euro/dollar put spread , to limit the downside of a risk rally to the premium paid, and going short on a 50/50 basket of euro/sterling and euro/Norwegian krone.

Written by Catherine Boyle, CNBC.com. Twitter:@catboyle01