Shelter Island Capital Management

As most pundits expected, or perhaps hoped, Macron led the field in the first round of the French elections on Sunday. These pundits now hope for his victory in the second round. Delivering your party’s votes to Macron in the past has resulted in the PASOKization of the French Socialist Party, which candidate got less than 2% of the first-round votes. Other parties may have taken notice of the socialists’ fate and choose not to back Macron. How will an EU crippled by Brexit and now pregnant with Ukraine’s war deal with President Le Pen?

Many observers believe that the war in Ukraine has created a united EU. But, it still early innings and national interests may still prevail. Observe Italy’s diligence in securing a gas pipeline deal with Sonatrach, the national oil company of Algeria, as soon as Spain changed its decades’ old position on the former Spanish Sahara (now Western Sahara) and pivoted towards Morocco’s stance. Morocco and Algeria wage a low-intensity war over that territory and the vast deep-water natural gas deposits lying under the Atlantic seabed between that former colony and the Canary Islands.

This major Spanish policy shift was sealed last week at dinner party where the King of Morocco played host to the Spanish Prime Minister and the Spanish Prime Minister played the role of the Head of State of Spain. As is customary, the pliant Spanish press diverted public attention from the King of Spain’s absence with a canard on whether an upside down Spanish flag was a symbol of Morocco’s contempt for its guests and their country. (In a similar vein, the press has declared two young businessmen guilty of profiteering from a €6 million mask supply contract to the city of Madrid at the outset of the pandemic, but has largely ignored that three high-ranking government officials were deposed by a judge in Madrid for gross mismanagement and fraud related to procurement contracts worth hundreds of millions of euros in the same period).

National interests still dominate in the EU

National interest is still the driving force of foreign policy of EU member countries. Germany’s about face on its energy supply, defence, and non-engagement in foreign wars policies is perhaps in the best interest of Germany, but not necessarily in the best interest of all EU member states. The common policy is driven by the Spaniard Josep Borrell (né José Borrell), the High Representative of the Union for Foreign Affairs and Security Policy. He is still reeling from the humiliation he suffered in Moscow in February 2021, when at the joint press conference with the Russian Foreign minister he learned of the expulsion of three EU diplomats that morning. He stated at the time that relations between the EU and Russia had hit rock bottom; so much for his predictive abilities.

Unfortunately, that episode may cloud his judgment; the best interest of the EU is to broker a ceasefire and a peace treaty both for humanitarian and economic reasons. Ukraine cannot win this war and every week that passes hundreds of civilians die and billions of euros in reconstruction costs accrue. That reconstruction will be largely paid by the EU. As has been the case with the Ukraine’s IMF program, emotional considerations and Germany’s interests will take precedence over standard operating procedure. Do not be surprised when billions in foreign aid go missing. Eight years ago, following Russia’s invasion of Crimea, we posted the following:

From the FT online edition tonight:

“The International Monetary Fund has identified a $15bn shortfall in its bailout for war-torn Ukraine and warned western governments the gap will need to be filled within weeks to avoid financial collapse.”

Unlike in Greece, the private sector lenders to Ukraine have not been bailed-in before this country received access to additional official sector aid. Ukraine is decidedly unable to meet its debt obligations; it has not been able to do so since the collapse of the Soviet Union. Who could oppose Ukraine getting much needed funding with no strings attached? While the Greek Government and its bailed-in private sector creditors come to mind, there is undoubtedly a lot of sympathy in the west for Ukraine’s plight. But one should not confuse political and humanitarian issues with an IMF program.

Garry Kasparov, the former six-time world chess champion from the former Soviet Socialist Republic of Ukraine, was the speaker tonight at the Alan Howard Conferences in London. He compared the Putin of the Sochi Winter Games of 2014 to the Hitler of the Berlin Olympic Games of 1936. He noted that while it took Hitler 20 months from the conclusion of the summer games to decide the Anschluss in 1938, it took Putin only 20 days from the closing ceremony at Sochi to the annexation of Crimea. Kasparov made a persuasive case for the US President to call Putin’s bluff by putting an end to his appeasement policies.

While all of these issues are undoubtedly very important, this financial crisis comes at a time when populist parties calling for quotas on legal immigrants from Eastern Europe to the more prosperous economies in the EU are gaining prominence. Their formerly radical agendas are full-heartedly espoused by mainstream parties. They also come at a time when the Samaras administration in Greece is faltering. It has steered Greece to meet a much larger number of the conditions set forth in the IMF program – which are usually resounding failures – than is the norm. Greece is not really asking the IMF to bend its very strict rules, as it knows this to be futile; rather it is asking its EU partners for some wiggle room, a small prize to show the Greek electorate that the sacrifices have not been for naught. He has been rebuffed and the country has been thrown again into financial chaos.

While Athens was burning today and the rest of European bourses were suffering a correction, SWMBO waxed triumphant on Germany’s great accomplishments and strength. No wonder The New Yorker reports she is the western leader for whom Putin shows more respect. They are meant for each other: two children of the Cold War as seen from the other side of the Iron Curtain.

Should EU leaders decide to toss a few more million into the Ukrainian war, who can be surprised when Greek voters chose to elect a rogue Government? Where do we go from here? This is not a rhetorical question.’

Why fight a losing war?

The EU may prove to be far from united as the energy crisis goes unresolved. Germany may have the flexibility to afford a deeper recession at this point as energy prices destroy demand and manufacturing capacity is shut down temporarily. It is unlikely that most other countries may be able to do the same without incurring severe damage to their economies. As EU voters realize that this energy crisis is here to stay for quite some time, they may be less willing to bear the cost of Zelensky’s resolve and may start thinking that his heroic resolve is more akin to stubbornness in the face of daunting odds. The Ukrainian President has already conceded that his country will not join NATO, which was the provocation that stirred Putin into action. What is the point of carrying on with a war that Ukraine is unlikely to win?

The West’s general contempt for President Putin’s invasion of Ukraine should be placed in the context of other regional military conflicts pitting Russia vs. former Soviet Republics. These conflicts include the two Chechen Wars (1991-2000). As recently as 2006, Russian security forces continued to operate in that region eliminating some of the leaders of a low-level insurgency there. Ramzan Kadyrov, the current Chechen leader, was appointed by Russia. Chechen Islamist rebels fought against the Russian Army and Bashar al-Assad forces in the Syrian Civil war as well as in the Donbas. Putin has been for decades allowed to pursue his interests with no adverse consequences. Does anybody remember Obama’s “red line” in Syria anymore?

Russian state resurgent under Putin

Putin was elevated to the presidency of the Russian Federation in 2000. In 1998, Russia had defaulted on its domestic debt in an abjectly corrupt move designed to bail-out domestic banks that had taken on too much rouble risk with foreign counterparties. Brent oil was at $27 a barrel when he came to power. Russia’s foreign exchange reserves were depleted, the country’s future was as bleak as its Soviet past. While the Russian economy has not performed particularly well for the average citizen, the Russian state has done very well these past two decades. Higher commodity prices and expropriation of private assets such as the Yukos oil company have provided vast resources to the state. The economic war waged by the West intends to harm Russia’s economy. Perhaps it will succeed at some point. In the interim, it is obvious that Western economies are already suffering greatly just a few months after the calamitous contraction of 2020.

None more so than the economics of the periphery of Europe. The end of the Omicron wave of COVID brought hope of a normalized 2022 tourism season. Yet the rising cost of living will leave fewer euros and pounds for vacations, not to mention the rising cost of airfare. Housing prices are also going up in many markets as new supply is becoming scarce. We should expect a new property developers’ crisis, as many homebuilders cannot deliver units within contracted cost because of rising materials prices. Some may choose to default tactically. Companies are already reacting to higher costs by reducing headcount and expenses. We read today in the press that BBVA will no longer supply “free” bottled mineral water to employees, this extra savings come on the back of a 3,000 head count reduction. The social-communist government in Spain is studying reinstating a ban on lay-offs for economic reasons (yet another form of expropriation, which will be contested in court at some time in the future when it will no longer matter).

The West’s Greta Thunberg moment

We are living through a new Greta Thunberg moment. Emotions override reason among global leaders once again. Political goals override engineering realities. It is the triumph of idealism; we would be the inhabitants of ‘The World as Will and Representation’. We are afraid that once the economic costs and the logistics and cost realities of shifting supply sources sink in, we will see a wave of protests in the streets of Europe not unlike the violent 2018-19 “gilets jaunes” protests in France. Some observers point to history and reflect that revolutions often take place when the economy tanks. We are not sure there are enough “revolutionaries” in the rapidly ageing periphery countries. Surely, something has to give. In the second round of the French Presidential election, a centre right candidate will face a nationalist radical (often depicted as extreme-right). The left is also more radical as it supports Jean-Luc Mélenchon, a former Socialist, and his “France in Revolt” party.

The financial cost of sanctions is also significant. While the direct cost of writing off a few hundred billion of financial and direct investments in Russia may be affordable, the indirect costs of smaller crops for lack of fertilizers, higher interest rates than expected before the conflict, higher inflation, and higher energy and commodity prices for longer will be fatal to many economies. This is especially true of energy dependent lower income countries such as Ethiopia, Somalia and most of the Sahel. This food crisis will lead to larger numbers of economic migrants looking for a brighter future in the EU.

We shall soon see how we cope with all these issues. But if history is a guide, it does not bode well for EU unity, as national interests will come back to the fore, as was the case with the Syrian refugee crisis or the pandemic. Let us not forget that closing borders and suspending free trade were the knee-jerk reactions to those problems.

The misery index, the sum of the inflation and unemployment rates, hit 22.4 in March in Spain. This figure is double that of the US and 10 points higher than the EU’s (which of course includes Spain’s outlier). In spite of the widespread misery, life goes on. There is no apparent Government crisis and very few people seem to be concerned.

Prime Minister Pedro Sanchez addresses the manifold crises his Godforsaken country faces with 1970s policy tools such as subsidies for gasoline and diesel and price controls for electricity and rents. The subsidies return to motorists some of the windfall tax receipts resulting from inflation and the price controls are, of course, a euphemism for expropriation of private property. Burying their heads in the sand seems to be working for now, politically. Conveniently, there is very little coverage in the not-so- independent and not-quite-free press. The war in the Ukraine overshadows most other problems.

The day of reckoning is nigh

Yet, soon enough, the day of reckoning will come with the same shocking randomness and sudden violence we saw at the outset of the euro area sovereign and banking crises in 2010. Foreign lenders are not often persuaded by nice words or good intentions. Eventually, they want to see cash. This is especially true when neither of the two largest political parties takes structural reforms seriously. In fact, the ruling coalition is actually trying to undo whatever little progress was made deregulating internal markets in the last decade. Very few developed countries have proven to be as fragile in the face of adversity as Spain. The pandemic brought the largest GDP decline in the OECD. The recovery in 2021 was the slowest of any developed country. Year-on-year inflation in March was a record-breaking 9.8%. We can marvel at the resilience thus far, but the Spanish formula is more fragile than ever.

At the same time, we have been living with an exceptionally indulgent European Central Bank. The ECB’s mandate primary focus should be inflation. But the ECB has more recently taken it upon itself to be the motor of economic growth in Europe, lender of last resort to governments, guarantor of the euro zone. This has gone on for a decade, so we now find ourselves with negative real interest rates of something like 8% or 9% in Europe. This is proving too much even for the ECB’s divided governing council, which all points to the ECB raising rates sharply, soon and fast.

There are very few western countries besides Spain where communists are in the government or where enemies of the state support the government in Parliament. This would be merely anecdotal were it not for the fact that on Friday after the cabinet meeting, the government spokesperson announced that property owners with a portfolio of more than ten dwellings would not be able to increase rents by more than 2%, owing to “the high rate of inflation” of the last three months. This expropriation will fail the constitutionality test but not before producing a lot of damage to the quality of the rule of law in Spain, which already has a weak standing. While we have seen a massive demonstration of farmers in Madrid two weeks ago, the labour movement is silent on the big problems, including falling real wages that afflict their members.

Spain has created a wonderful system where trade unions have no dues paying members but subsist on government handouts. Ditto for political parties. What passes for a business federation is an organization run by a person with not much business experience. This person generally does not speak for the country’s large corporations, who do their own lobbying.

Corporates are long in the tooth

We are not sure there is a better alternative as the business community in Spain is not exactly teeming with talent. Recently, Iberdrola, an electric utility, became the largest company by market capitalization in the country, overtaking Inditex, whose stock has reacted poorly to store closures in Russia and lockdowns in China. It is quite revealing that the top position is held by a company with its roots in 19th century technology as it overtakes a company with a business model that is even older.

You may ask, why are we critical of Spanish management when so many companies and their leaders are showered with international awards and distinctions. Probably because total shareholder return is the metric we value most highly. On this metric – and since Inditex went public in May 2001- only 13 other Spanish public companies have total shareholder returns above 8% CAGR – compound annual growth rate. (Ferrovial, an operator of airports and toll-roads, did not go public until 2004. The stock has returned 11.26% CAGR since.) Five of these companies are electric utilities. The best performer, CIE Automotive, is in the auto-parts business. There is a glass bottle maker, a global leader in sausage casings, a manufacturer of railroad rolling stock, a cement company, an insurance company, and two engineering and construction companies. Most of these companies are long in the tooth, several of them have been around for more than 100 years. This sample is representative of the lack of entrepreneurship and innovation that afflicts the Spanish business landscape.

Given this sorry state of affairs for investors in Spain, management compensation at underperforming companies is an aberration that can only be explained by poor corporate governance. We often question the independence of independent directors. We know full well that most CEOs, or executive Chairs, in Spain value loyalty well above independent thinking or competence, and it shows. Independent thinking is generally thought to be a negative with few exceptions.

Thus, not a single management team ever doubted why they were throwing billions of euros at acquisitions in Latin America. When Banco Santander acquired Banco Rio de la Plata in 1997, we asked what did they know about Argentina that Gregorio Perez Companc did not. We made that obvious observation because, at the time, Mr Perez Companc was the wealthiest person in that country and everything he owned there was up for sale. In 2001, the Argentinian Government abandoned the convertibility of the peso into US dollars, put in place capital controls and the infamous ‘corralito’ and defaulted on its external debt for the sixth time in the country’s short history.

We know of only one instance when a director was not slated for renewal by the controlling shareholder of a listed company because during his tenure he had not once opposed any point of debate in board meetings. This state of affairs may be about to change, as just this morning we read press reports that Blackrock will oppose top management’s compensation at Telefonica. This is doubly interesting as they are currently the company’s single largest shareholder, with a 5.1% stake.

Fathers and sons (and daughters)

Nepotism is the other silent killer of initiative in Spain. When Ana Botin posted on Twitter that she had to overcome tremendous difficulties when she started her finance career because the senior people around her were old white men, she did not do herself any favours. As far as most people can tell, her main qualification to hold her current position is to have been her father’s daughter. This is also the case with Marta Ortega, the brand new chair at Inditex, Marta Alvarez at El Corte Inglés, and Sol Daurella at Coca Cola Europacific Partners. What is interesting about their nominations is that, in some cases, some of these candidates were chosen over their male siblings, which is good news perhaps for gender equality, but not for curing nepotism. Thus for many Spaniards the HBO series ‘Succession’ is art imitating life. Nepotism defeats any attempt at fairness or equality of opportunity. It also discourages entrepreneurship as the scant domestic capital pools are generally earmarked to family endeavours.

Rote, rote, rote your boat

Some of the lack of entrepreneurship is a result of labour and corporate legislation that punishes failure unduly. The rest may be attributed in equal parts to education and culture. Education in Spain is pernicious. As a friend of mine described brilliantly, the best schools in the country take on B+ students and turn them into B- students. The first problem is a national curriculum that is both mandatory and heavily politicised. There is – or there used to be before the pandemic resulted in everybody passing irrespectively of grades – much emphasis on rote learning and very little on oral and written communication skills, critical thinking, or working in teams, as occurs in the workplace. Spaniards are still in awe of candidates who become State Lawyers or Notaries Public because of their talent for memorizing thousands of pages of information and regurgitating them without fault in an oral exam. How this prepares these mandarins for the difficult task of making policy decisions is unclear.

We recently listened to a very interesting interview in the ‘Invest like the Best’ podcast with David Rubenstein, a co-founder of the Carlyle Group. He was very concerned about the 14% of Americans who are functionally illiterate; i.e. people who cannot read at the 4th grade level (9 to 10 year olds).

We are afraid we do not even want to ask that question for Spain. Spanish culture is rich in tradition and folklore. Yet when it comes to reading, most people in Spain prefer to get their news from TV or the radio. Newspaper and magazine sales have declined precipitously. Book sales have always been low relative to household income. In fact, even though surveys suggest that Spaniards read on average 5 hours and 48 minutes per week – just ahead of Germans, Canadians or Italians – the fact is that you can count the number of people reading a book in public transportation or on a packed beach with the fingers of one hand. Most people pay lip service to the value of a good education but very few people actually get one.

No pain and no gain

In general, Spaniards are risk averse. Many educated people prefer a government job to the vagaries of the private sector, and many of them get one. The public sector was once again the fastest growing employer in 2021. Partly because of the increase slice of the public sector in the labour market, productivity has not grown very much lately.

The median household income has not grown very much either since 2009, as wages have generally not kept up with inflation and other sources of income have declined, especially returns on savings because of falling interest rates and higher taxes. Only 5% of Spanish households have a disposable income above $100,000 vs 11.7% in France. 51.2% of households have a disposable income above $35,000 vs. 72.5% in France.

Governance of government a blemish

The governance of government is also poor. A Council of Europe report published last week states that Spain has not fully complied with any of the 19 recommendations on corruption the Council made in 2019. Obviously, the Council of Europe knows a lot about corruption since some of the most corrupt countries in the world – such as Russia, Belarus, Moldavia and Ukraine – are among its members. Nonetheless, it is another blot on the landscape.

This is not good PR when you have as large an external debt as Spain does. Aldi Nord, the German supermarket chain announced it is raising prices on 400 food items by between 20% and 50% as of today; we shall soon see how German officials react to the public outcry that may ensue.

Sanchez is likely to set price caps on food items as well. This will lead to kilos that weigh just 750 grams, or scarcity, or both. If the playbook for this new crisis in Spain is to continue to follow the tools used by Peronist Governments in Argentina, we may soon see capital controls and a corralito here as well. If you think this is far-fetched, you should remember that this is what happened in Cyprus and Greece.