Marcuard's Market update by GaveKal Dragonomics
Investor enthusiasm for government debt from the eurozone’s southern periphery persists unabated. Last week the yield on Spanish 10-year bonds dropped to its lowest level since September 2005. Before too long, however, investors will find themselves bumping up against some hard truths imposed by simple accounting identities.
As some of our readers will know we have never been great fans of the national accounting equation: gross domestic product equals consumption plus investment plus government spending plus the net external balance—GDP = C + I + G + (X-M). We never understood why having a bigger government should make us feel richer. Nor, why taking the goods and services in labour to produce and exchange them with a bunch of foreigners in return for their promise to pay us at some point in the future should contribute to our wellbeing.
The only people who believe that a current account surplus is the sign of a well managed economy are called “mercantilists”. They confuse the current account with a profit and loss statement and always end up broke. To any simple mind the only thing that matters is the consumption plus investment element of the equation. That’s because consuming today makes us feel good today, while investing facilitates more consumption for our grand children.
In this spirit, let’s have a look at consumption plus investment in Spain, always remembering that the results would be much the same for Italy. Since its peak in 2007, consumption in Spain has declined by -12.5% relative to GDP and by -18% in absolute terms.
In a depression, the current account always improves since returns on invested capital collapse. Capital flees and because the balance of payments must balance out at zero, a deficit in the capital account has to be offset by a surplus in the current account. As a result, the Spanish current account has moved from a deficit equal to 10% of GDP to a surplus today of 2.5% of GDP, with unemployment going through the roof to more than 25% and government debt soaring from 30% of GDP in 2007 to close to 100% today. Someone has to pay all the unemployment benefit for the 25%.
Ultimately it will be children who are not yet born. Meanwhile, today the average Spaniard has a standard of living roughly -20% below the level ten years ago. Bravo for the euro!
Now everybody says that Spain has “turned the corner” and that there is “light at the end of the tunnel” (as US general William Westmoreland said about the Vietnam war, just weeks before the Viet Cong’s surprise Tet Offensive). Let’s hope there really is some light, given the beating Spain’s poor citizenry has taken, but we are not confident.
Interest rates remain well above the nominal growth rate of the private sector (consumption plus investment), which is around zero. Unemployment remains incredibly high. The budget deficit is still at 6.5% of GDP. Bank lending continues to collapse and the bad debts in the banking sector are constantly being revalued. We are told that young Spanish citizens are leaving “en masse”, that the Spanish population is falling because of a fertility rate which collapsed ages ago, and that Catalonia is restive and could do a Crimea.
In recent years, eurozone investing has been simple. You had to invest in convergence trades when panic reigned and in divergence trades when the International Monetary Fund told you everything was under control. Over the last three years, we have played the eurozone’s markets either by riding Portuguese debt or by being long Italy and short France.
We are not sure there is much mileage left in these two low risk strategies. It may be time to abandon them in favour of Asia.
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