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Categorized | Economy

So far, the pain is likely to stay mainly in Spain

Posted on March 30, 2012

A Great Quarter is coming to an end. Stock markets have rallied consistently since the turn of the year, with no significant pullback. Helped, doubtless, by deep pessimism at the turn of the year, that made this the best opening quarter since equities entered their bear market in 2000.

For the S&P, its rise of about 11.5 per cent is the strongest opening quarter since 1998. For world stocks, the rise has been similar. In Japan, the Nikkei 225 had its best opening quarter since 1988, before its long slump started – although note that its 19 per cent rise is almost entirely a function of the weakening of the yen that followed the Bank of Japan’s surprise decision to loosen monetary policy. Measured in dollars, its rise was 11.7 per cent. Among the bigger markets, perhaps China was the only significant disappointment, with stocks gaining only 3 per cent for the quarter.

Market rallies seldom persist in straight lines. A pull-back before would arguably be healthy. And there is a risk of a repeat last year’s script, when a strong open was followed by a tough summer.

Why was this quarter so good? Two factors have justified the gains. First, the US economy has surprised on the up-side. As analysts have improved their forecasts, so that rate of positive surprise has dwindled, and the rate of improvement in critical measures such as jobless claims has fallen off. Next week’s data, highlighted by Monday’s supply-managers’ surveys and Friday’s payrolls, may determine whether this is the time for a pullback.

More importantly, there has been news from Europe. The European Central Bank’s long-term refinancing operations (LTROs), bestowing more than a trillion euros on European banks for three years at low interest rates, averted a crippling credit crunch, removed the risk of an imminent banking collapse, and engineered a sharp reduction in the rates that the Italian and Spanish governments have to pay on their debt. That eased the crisis, and gave politicians more time to negotiate longer-term solutions to the eurozone’s fiscal problems.

Did the ECB do anything more than relieve the risk of disaster? And are politicians really using the space they have been offered to achieve any thing more useful?

The answer to the first question appears to be “no”. Governments from Lisbon to Athens are finding it as hard as ever to balance the books.

The answer to the second could determine whether markets endure a drubbing to match 2011.

Beyond Brussels, the focus is now on the Iberian peninsula. Portugal, the market believes, must brace for a second bailout. As for Spain, it has failed to join in with the rest of the party this year.

The Ibex index of Spanish stocks fell 4 per cent for the quarter, in euro terms, led mainly by domestic banks and construction groups – the sectors most affected by the Spanish property bubble which is still far from completely unwinding. Meanwhile its government bond yields fell below 5 per cent, thanks to ECB-fuelled buying by banks. Now those yields are rising once more. They briefly hit 5.5 per cent, and have never returned to normal levels.

Part of the problem is political. Spain’s new prime minister Mariano Rajoy annoyed investors by announcing that he was watering down his public deficit targets for this year from 4.4 to 5.8 per cent of gross domestic product. The juxtaposition of violence in the streets during Thursday’s general strike with Friday’s budget, featuring an immediate 6 per cent rise in electricity prices and a 17 per cent cut in government spending, rammed home just how hard it will be to win popular assent for austerity – particularly when the economy is already forecast to contract by 1.7 per cent this year.

Not only Spanish politicians are being tested. European finance ministers yesterday reached a compromise in their attempts to strengthen the “firewall” against further sovereign debt problems. There will now be a total of €700bn available to aid governments who cannot finance their debts. But this sum was lower than many had hoped. It remains far less than the combined borrowing needs of Italy and Spain for the next two years.

It is encouraging that finance ministers agreed this without being forced to do so by a crisis. If nerves return, however, it may not be enough to convince investors that contagion from one market to another can be averted.

Markets are not oblivious to this; that is why Spanish securities have performed so badly while others have rallied. As the rest of Europe has rallied convincingly, the judgment at present is that contagion can indeed be contained. Any pain in Spain will stay there. But it would not take much to shake that confidence, or at least for a pullback in risky assets to put that confidence to the test. After a Great Quarter, the danger is that markets enter a Latin Quarter.