How to play a rebound in markets without buying Europe

published 11 June 2012

Another one bites the dust.

Portugal, Ireland and Greece have all accepted bail-outs from the eurozone. Now Spain has followed in their footsteps.

Over the weekend, Spain said it would seek as much as €100bn from the eurozone's rescue funds, to recapitalise its banks.

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Markets have rebounded in early trading, as you might expect. So what is the deal all about and can it save the eurozone?

How a property bubble ruined Spain

Spain's problems are very similar to those of Ireland. Spain's eurozone nightmare started as a private sector bubble, rather than a public sector spending binge.

Overly-low interest rates led to a huge property bubble. Prices rose too far and too fast. Builders were encouraged to build too many properties. So you ended up with the lethal combination of over-supply plus over-pricing. Then came the bust.

Unlike Ireland, Spain's bubble took time to deflate, partly because its banks used various extend and pretend' tactics to conceal the level of carnage in the market. But with the economy weakening rapidly, the property market is following suit.

Most people didn't believe Spanish banks were ever being realistic about the level of property-related losses on their balance sheets. And they were right. Last month's bail-out of Bankia, Spain's fourth-largest bank, just proved it. And there are more problem banks where that came from.

So here's the difficulty. The Spanish government needs to bail out Spain's banks. But the Spanish government doesn't have enough money to do that. It can't borrow more on the market, because bond yields are already too high.

Up until now, Spain has tried to avoid requesting a bail-out from Europe. That's because it doesn't want to have the International Monetary Fund and the rest of Europe telling it what to do.

The deal now is that it will ask for the €100bn, but that it's solely to recapitalise the banks. That means it won't technically have to have the same levels of oversight as the bail-outs of Ireland, Greece and Portugal incurred.

Europe's bail-out funds will lend the Spanish government the money at low rates. This will then go into a specific fund created to recapitalise the banks (the Fund for Orderly Bank Restructuring, or FOBR).

The big problem with the Spanish bail-out

We'll put aside the question of precisely where the money is going to come from for now. Italy, for example, will now have to guarantee 22% of the funds, which seems a stretch given the state that the country is in. I suspect they'll find a way to fudge it somehow.

There's a bigger, deeper structural problem with this way of bailing Spain out. The loan from the eurozone almost certainly (in practice, if not in theory) will jump the creditor queue. In other words, if the Spanish government ever runs out of money, then the European loan will get paid ahead of any private sector bondholder.

This is what happened with Greece. The private sector ended up taking huge 'haircuts', while the public sector (on paper at least) remained whole.

By bailing out the banks this way, not only does the Spanish government end up owing more money, private sector lenders have been pushed down the line for payback. In other words, lending to Spain has just become even more risky.

And by extension, so has every other European sovereign that might potentially need a bail-out Italy, for example. So the question is, why would any private sector investor in their right mind lend money to a troubled eurozone sovereign now?

I can't think of a good answer. And that suggests that without more action from Europe to prevent it yields on European debt should rise even further.

What you should buy now

In short, there are lots of reasons to be sceptical of this deal. It's the usual eurozone fudge that we've all become thoroughly sick of. And I wouldn't be keen to invest in eurozone debt right now.

However, stocks are a different story. Everything has its price. And some European markets are pricing in some very gloomy outcomes indeed. The one good thing about the Spanish bail-out is that it shows that there's still an appetite in Europe for keeping the whole show on the road, whatever happens to Greece.

Of course it's risky. But investing in anything is risky. It's all about the gap between risk and reward. We've already talked about investing in beaten-down European stocks on a number of occasions. In the current issue of MoneyWeek, I take a closer look at Italy, which looks temptingly cheap. If you're not already a subscriber, you can subscribe to MoneyWeek magazine.

However, if you really don't want to touch Europe, you don't have to. There are some other battered asset classes that look worth buying now. One in particular is gold mining stocks. These have had an appalling time over the past 18 months or so.

These stocks were already on the floor. The recent panic over Europe has just beaten them down even further. Relative to gold, they are as cheap as they've been since the bleak days of 2008. But it looks as though they might just be turning a corner now, with the sector bouncing sharply since mid-May.

If you don't already own a stake in the gold mining sector, I think now could be a good time to get back in. One unit trust option is the BlackRock Gold and General Fund. If you'd rather use an exchange-traded fund (ETF), then the US-listed Market Vectors Gold Miners (US: GDX) tracks the major miners, while the more risky junior mining sector can be bought via the Market Vectors Junior Gold Miners (US: GDXJ).

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.