Description

We are recommending a short of the Spanish economy as we believe that the fundamental outlook is in line with what we have seen play out in Florida and recent data points indicate the fundamentals are starting to deteriorate. It is very hard to short individual names given the borrow can be tight and so we are recommending a short of the Large Cap IBEX index (you can also play this theme in several other ways through the derivatives market that are very compelling and in some cases offer a better risk/reward – cds, puts, customized basket, etc). Shorting the IBEX index at current prices offers 40%+ upside over the next 12-18 months and it is hard to see downside of more than 10-15% (as I mention above for those who are willing to be more creative, the risk/reward can be improved through the derivatives market).

The Spanish housing market has appreciated rapidly over the past 5-7 years as the economy experienced the perfect combination of declining real interest rates, lax credit underwriting standards, massive leverage, declining cost of capital, etc which created a reflexive process of rising home prices that fed on itself. Spanish home prices doubled between 2000 and 2005 while the average home price in Europe increased by 40%. More importantly, home prices have appreciated at a much faster pace than income levels and the average home price in Spain is now approximately 7x the average household income, up from 4x between 1995 and 2000 (looking at it this way is similar to a p/e ratio for homes). To put that in perspective, the comparable ratio for the UK is current 6-6.5x (up from 5x at the previous peak in the early 90’s and 3.7x on average over the past 40 years). The comparable ratio in the US was 5.5x at the peak (this is actually median household price to median income) vs 3.7x on average for the past 20 years. We have not seen p/e’s this high in the housing market in decades. When you consider that the largest % of most people’s net worth is tied to their home, it is easy to see how the impact of a severe housing downturn could have a dramatic affect on consumer spending, access to credit, etc.

As real interest rates were declining from 00 to 04and more and more borrowers were taking out adjustable rate products, the cost of a mortgage relative to one’s income was declining and thus banks were willing to give out more debt relative to the value of the home. This allowed borrowers to be willing to pay more for their home which caused home prices to increase and after a couple years of appreciating home prices, bank standards for giving out loans deteriorated faster as they felt they had a large margin of safety because home prices were increasing so rapidly. This along with a more robust securitization market and generally favorable economic environment, lead to declining risk premiums and thus lower effective mortgage rates and massive increases in the amount of leverage borrowers could take out against their home. And all this continued even as the ECB was raising rates between 04-06. Due to declining risk premiums, lax underwriting standards and the securitization market, the increase in rates had a very small impact on the cost of credit and availability of credit.

This dynamic was pervasive throughout Spain as a strong housing market created new jobs, more consumer buying power and overall strong economic activity (residential investment as % of GDP increased from approximately 4.5% in 1996 to approximately 10% by the end of 2006). We have seen the same types of dynamics in Spain as we saw in Florida in terms of speculative buying of second homes, massive building, etc.  It is also worth noting that corporate credit has been very high and due to cheap/easy access to credit, this has allowed many companies to invest in unproductive projects/assets that increase eps (due to ROE’s above the cost of financing) but are not the most efficient use of that capital. Just as in the US, this dynamic created a massive amount of liquidity as credit growth and asset value appreciation fed on one another. Non financial corporate debt and household debt has grown at a CAGR of approximately 20% since 2000 and is currently 200% of GDP (which is approximately in line with the UK and US). The equity value of Spanish listed companies is approximately 100% of GDP which implies an EV/GDP or EV/Sales ratio for all of Spain of 300% (up from approximately 95-100% throughout most of the 90’s).

There are several recent data points that indicate that the above dynamics are reversing. We have gotten numerous data points from industry contacts about vacant homes for sale, rising inventory levels, declining consumer spending, etc. In addition, numerous recent housing statistics indicate declining existing homes sales, tightening of mortgage and other types of credit, slowing housing starts and month over month home price declines. Based on the above dynamics, we feel that the reflexive process that has lead to appreciating asset values in Spain (much faster than the growth in GDP) is reversing and the effects will be a slowdown in GDP growth and a much faster decline in asset values.

The massive consumer and corporate credit growth has lead to historically high and unsustainable ROEs which has allowed the IBEX to trade at a 3.2x price/book multiple which is the highest valuation (other than a brief period in 1999) that it has traded at in the past 20 years (its average p/book multiple is 1.9x over the past 20 years). The decomposition of ROE indicates its core drivers are leverage, margins and capital efficiency. Even assuming small improvements in capital efficiency over the past 20 years, leverage and margins are at levels that are unsustainable due to the dynamics we have described above. The deterioration in the housing market is going to cause credit growth to slow and likely contract and margins have been inflated as consumer buying power has grown much faster than wages due to easy/cheap access to credit which has lead to sales growth in excess of wage growth (which has contributed to ebit margin expansion). In addition, as in the US, and globally, for many years, the flattening of the global economy lead to disinflation in the price of many goods (CPI grew faster than PPI) which helped gross margins expand. We are seeing that dynamic change as commodity prices and wages globally are increasing faster and productivity increases are slowing. These dynamics are likely to lead to compression in ebit margins and declining leverage levels which will cause ROEs to be under significant pressure. Spain has been a significant beneficiary of these trends which are now changing.

We believe that the declining home prices, deteriorating consumer spending, credit contraction and overall economic weakness is going to lead to declining ROEs (from peak levels of 20%+ back to/below average levels of approximately 13-15% over the past 15-20 years). This correction process is going to cause the price/book multiple to contract to under 2x book (closer to its historical average, although the adjustment process is likely to over-shoot on the downside) which is likely to lead to a 40%+ correction in the value of the IBEX.

Even if you look at the value of the IBEX relative to comparable UK or European indexes, it is overvalued. The IBEX trades at approximately 3.2x book and an EV/Sales of 2.3x vs 2.3x and 1.4x, respectively for a group of European and UK indexes.

The risks to this trade are the following: 1) companies in the IBEX have sufficiently diversified their businesses as many of them have increased their exposure to Latin America and other regions outside spain, 2) the government is running a surplus and has already started to increase spending dramatically (2/3 of 3Q 07 GDP growth) to offset housing weakness and 3) the ECB decides to massively cut interest rates. We will touch on the risks briefly below.

Approximately 50-55% of the IBEX sales are exposed directly to spain. Another way to look at it is, approximately 40% of the index is exposed to consumer discretionary and financials and 30% is exposed to industrials and highly geared utilities. We believe the exposure is enough to generate the expected returns.

If we are right on the potential housing declines and credit contraction, we think it is highly unlikely that they government can bail out the economy as their budget surplus could rapidly become a deficit as slowing sales taxes and declining property taxes cause federal revenues to decline. As a member of the ECB, they also are required to not run more than a 3% budget deficit which limits their flexibility.

Massive cuts in interest rates could offset weakness here but there are cheap hedges for that. It is also worth keeping in mind that over the past few years as the ECB has raised rates, credit has grown at an even faster pace as credit creation has largely grown outside the central banking system. It may take truly massive cuts in interest rates to offset the costs of widening risk premiums that are likely/beginning to occur and even with huge cuts, the ECB may not be able to offset the fact that credit tightening will limit access to credit at any cost. We are seeing these dynamics play out in the US today.

IBEX constituents have diversified their exposures outside Spain

The government tries to spend its way out of the problem

The ECB decides to cut interest rates significantly

Catalyst