The big question in Europe remains the fate of Spain

14 May 2012 by Jim Fickett.

You have probably seen the headlines about the people of Greece rejecting, in the latest elections, the austerity imposed by core Europe. Confidence that Greece will stay in the euro zone is slipping. The biggest consequence of this situation is not a possible Greek exit, which is survivable in and of itself, or even a further exit by Portugal, but rather a possible loss of confidence in the fate of Spain or Italy. The Financial Times reports:

Yet many in the markets worry that if the official creditors such as the European Union lose all their money on Greece, will they be ready to stand behind Rome and Madrid? The premium Spain pays to borrow over Germany reached a fresh euro-era record of 485 basis points on Monday.

Indeed, foreign investors appear to have drawn their own conclusions: selling by non-domestic bondholders in the past nine months has amounted to €200bn for Italian government bonds and €80bn for Spanish debt, says JPMorgan. Non-domestic investors hold about €800bn in government bonds in the two countries. …

The fact some Spanish and Italian banks have used cheap ECB loans to buy more domestic sovereign debt may only make them more vulnerable. …

Banks say that regulators have recently broadened their demands for contingency planning, requiring them to model for a wholesale collapse of the eurozone rather than just a Greek exit. “Five or six weeks ago the requests became broader,” says one banker. “But frankly, it has not been much use.”

All investors should be prepared for very volatile markets. In my view it is very foolish to be chasing yield in low-quality or long-term debt just now. Best to stay mostly in very high quality, short-term bonds, and the equity of very stable companies.

Many are warning that an expanding debt crisis in Europe could soon lead to loss of confidence in Japan and the US as well. This would be logical, and it is certainly possible, but I doubt it. So far the pattern has been for the markets to ignore the fundamental long-term risks, and just desert the worst corners, one at a time, in the face of imminent default risk. The US and Japan will are very unlikely to default, either through non-payment or high inflation, in the short term. I would guess (though it is only a guess) that “flight to quality” will continue to mean US Treasuries for some time yet.