09 June 2008
Global Equity Strategy
44 20 7883 6477
firstname.lastname@example.org Peripheral Europe: where next?
Jonathan Morton When exchange rates don’t adjust, domestic price levels have to, and this tends
1 212 538 9853 to create far more of an asset bubble (e.g. Hong Kong 1993, Middle East today)
or deflation (Germany 1998–2003).
44 20 7883 6480
Stay short of domestic Spain and Ireland. (1) It is probable that house prices
email@example.com will fall c20% from here. The house price/wage ratio is 50% and 60% above
average in Spain and Ireland (compared to 3% and 35% in the US and UK),
44 20 7883 6476 respectively. The OECD claims housing is overvalued by 16% and 33% in
firstname.lastname@example.org Spain and Ireland, respectively, compared to 10% in the US. (2) Housing is still
very oversupplied: starts per capita are nearly 4 times the US in both countries
44 20 7883 6484 and would have to fall 30% and 50%, respectively, to get to previous cycle lows.
email@example.com (3) Leverage looks extreme, with credit/GDP of 40% above trend. (4) GDP
Sebastian Raedler growth is abnormally geared to property, with finance and construction at peak
44 20 7888 7554 accounting for 38% and 45% of jobs growth in Spain and Ireland, respectively.
firstname.lastname@example.org The PMIs are now consistent with close to zero growth. (5) There has been a
big loss of competitiveness: the Spanish current account deficit is 10% of GDP
and Ireland’s is 6%. Spain and Ireland have the lowest export exposure to
emerging markets, and Spain has the worst productivity record in the OECD.
What can be done? 80% of mortgage debt is linked to short rates, which are
now expected to rise in Europe. Thus, the only choice is significant deflation
(and yet the real effective exchange rate is 10% and 21% overvalued in Spain
and Ireland, respectively) or massive fiscal easing (with government debt/GDP
low in Spain and Ireland). In our view, both will be required, resulting in
Irish/Spanish bond spreads rising to 70bps from 20bps currently, threatening all
domestic stocks (utilities suffer from a higher discount rate).
Is it in the price? Not in Spain. Its respective P/B and P/E relatives are still
37% and 15% above the average. Domestic Spain has outperformed 1% YTD.
Domestic Spanish banks trade on a 10% premium on pre-tax, pre-provisioning
profits to continental Europe banks. Irish banks are cheap, but still trade on a
27% premium to UK banks (on underlying profits). Stocks with high exposure to
Spain or Ireland that are cheap to short and Underperform-rated are Inditex and
Bank of Ireland. The following are expensive on Credit Suisse HOLT, trades on
a premium to its peer group and has negative earnings momentum: Iberia,
Bankinter, Mapfre, Ryanair, NH Hoteles, Zardoya-Otis and Vocento.
What about elsewhere? Greece has a current account deficit of 14% and Italy
is close to recession, but we would not short banks in these countries for the
following reasons: (1) Customer leverage is low: credit/GDP is less than half the
average of Ireland and Spain. (2) Bank leverage is low, with particularly high
deposit ratios. (3) In Italy and Greece, 35% and 30% of bank lending is to
property compared with 64% and 84% in Ireland and Spain, respectively.
(4) Housing is less overvalued. (5) The cost/income ratios are higher, implying
more self-help potential. (6) Italian banks trade on a 28% discount to Europe. In
Italy, though, with debt/GDP of 96%, bond spreads could widen beyond 100bps
(from 38bps now), and thus we would sell domestic plays with negative
earnings momentum, such as Mediaset and Mediolanum.
DISCLOSURE APPENDIX CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, INFORMATION ON
TRADE ALERTS, ANALYST MODEL PORTFOLIOS AND THE STATUS OF NON-U.S ANALYSTS. FOR OTHER
IMPORTANT DISCLOSURES, visit www.credit-suisse.com/ researchdisclosures or call +1 (877) 291-2683. U.S.
Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors
should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should
consider this report as only a single factor in making their investment decision.
09 June 2008
(6) Low exposure to emerging markets, as shown below.
Figure 22: Ireland and Spain have relative low exposure to emerging markets
Exports to developing countries, % total
Ireland UK Spain European France Germany Austria Italy Greece
In addition, Spain is more exposed to competition from emerging markets than the
European average (35% of total imports come from emerging economies, 31% in the EU).
The positives: fiscal surplus and demographics
We, of course, acknowledge that both Ireland and Spain have the fiscal flexibility to
support their economies (both countries have budget surpluses and central government
debt/GDP ratio of 21% and 30%, respectively).
Figure 23: Fiscal debt to GDP (central government, 2007)
Gov ernment debt/GDP
But investors always underestimate the degree to which fiscal positions deteriorate into a
sharp economic downturn as tax revenues decelerate. In a normal downturn we would
expect the cycle alone to add about 2-3 pp to the fiscal deficit; for instance, in 2000–03 the
deficit rose from 0% to 3.1% of GDP in the Euro-area. (Government revenues rose 1.5%
and spending 9% in real terms.)
Global Equity Strategy 9