Misreading Spain

September 16, 2009

That’s probably because it has performed more or less in line with key U.S. indices, rising about 30% year-to-date.

Those gains are respectable, and some good news from EWP’s key holdings will probably push the shares up even further in the short term. However, using any spikes as an unloading or short-selling opportunity could now make sense since the fund is dangerously close to being far overvalued.

EWP is a whopping 42% weighted in Banco Santander and Telefonica, meaning any good news from these companies has a huge upward pull on the fund’s market capitalisation.

On Monday, Deutsche Bank upgraded Telefonica to buy, helping the shares to climb on a day which was mostly in the red. Banco Santander is likely to get some positive attention too when it lists 15% of its Brazilian subsidiary on the Sao Paulo Stock Exchange in October. The deal is expected to generate up to €2.3 billion.

But Spain is one of the most misunderstood economies in Europe. This is partly to do with the euro, whose relative strength somewhat masks the underlying realities. The truth is that Spain is far more vulnerable to its internal political environment than many investors realise.

Right now, the country is a political nightmare. Spain’s haphazard socialist government has spent the best part of this year pushing through equal rights reforms which make it increasingly cumbersome for firms to hire. Unemployment is over 18%, while in the southern parts of the country it’s closer to 25%. That’s roughly the same level as back in 1996, the last time the party was in power.

Needless to say, it’s hard for big firms to keep growing in that kind of environment. In Spain, these periods of stagnation can go on for a long time: over the 20 years preceding the beginning of the country’s boom in the mid-90’s, inflation averaged around 4% a year while unemployment remained stubbornly high. The government was forced to borrow from banks to pay social security.

And although it might seem a whole world away, the building trade dispute between China and the U.S. looks ominous for Spain. An increase in protectionist policy towards emerging markets at a global level will severely hamper the growth of EWP investments such as BBVA, which recently bought Guaranty Bank assets.

Spain is the second largest investor in Latin America after the U.S. EWP holds Iberdrola, Repsol and Telefonica, which derive a substantial amount of their growth from Latin American investments and are really vulnerable to any slowdown in global trade.

I’m not saying that the country will revisit its pre-European Union woes. But consider that at the height of the economic boom, EWP traded at $69 a share. That was in a time of record savings (€21,800 per capita), all-time-low unemployment (11%) and massive emerging market growth.

While it’s still about 40% away from that target, any further increases above its current valuation will surely be unsustainable, at least until political and economic conditions ease.

 

 

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