Shelter Island Capital Management

As expected, the Spanish PM has reshuffled his cabinet. Gone are his loyal and ideologically orthodox, albeit generally incompetent and in some cases, even possibly corrupt, advisors. In with the new, out with the old quite literally as the new ministers are younger and more capable on paper. The slow burner intervention of Spain’s government by its creditors is taking shape ahead of the possible disbursement of EU Next Generation Funds. As is the case in other periphery countries, the Communist ministers have not been touched for two reasons. First, they are still useful to Sanchez who is not quite ready yet to call a snap election. Secondly, they wield no real power, and when they do try to do some further damage to the economic recovery, such as their minimum wage increase proposal, they are easily sidelined as their salaries and pensions are far more important to them than their principles. They are Marxists indeed, but of the Groucho faction. This instinct to cling to the trappings of power is not unique to Spanish far left politicians; the Five Star Movement in Italy led the way with a most Italian pragmatic approach to preserving sinecures.

Those who believe that the overhaul of Sanchez’s inner circle is a welcome change should curb their enthusiasm. Sanchez referred to the opportunity for growth and renewal presented by the EU’s New Generation Funds as “The Great Leap Forward”. Whoever writes his speeches is either a comic genius or as ignorant of history and all other subjects as his boss. In any case, the Euro Group got their wish for a technocratic government led by the Deputy Prime Minister Nadia Calvino who is far more popular in Brussels than she is in Spain. This is because most businesses have receive very little help from Government funds even as they were forced to shut down, unconstitutionally, as we now find out when it no longer matters. The strings that come attached to EU funds will make it nearly impossible for most employers to access any of these funds. They will go straight into the pockets of the shareholders of the large bureaucracies that were set up by the large Engineering and Construction companies and other Government contractors to profit from twenty-five years of EU development funds.

The lesson not learned from that experience is that when you invest tens of billions of euros in low return or redundant infrastructures, productivity growth does not improve. Worse yet, somebody, usually taxpayers, are left holding the bag for maintenance costs for decades. Take 5G network deployment; operators seem to be waiting for these funds before they start their rollouts. On a recent high-speed train trip from Madrid to Malaga, we noticed that Vodafone’s signal starts deteriorating just 10 minutes outside Madrid when 4G service became first 3G, then E. A self-respecting country would take back their license and their spectrum for not meeting minimum service quality requirements, not in this case. It would appear that the regulator has chosen Britain as the benchmark for service quality instead of the average EU market. In other parts of the world, RENFE, the high-speed train operator would have perhaps taken the initiative of providing Wi-Fi service on the train. Providing their customers with data connectivity would be seen as an aggressive intrusion into another industry. Customer service is an alien concept in the medieval mind-frame of protected gilds that appears to drive Spanish business practices.

With the Communist faction of the Government neutered and becoming increasingly irrelevant, Sanchez still needs to find a way to pivot towards the centre if he is going to win the snap election. For this, he needs to play his cards very well in the pretend negotiations with the Catalan secessionist Government. A very perceptive observer of Spanish politics suggests that Sanchez will attempt to accommodate some of their demands and reject outright independence. He will then turn to the electorate with the message that he had given in as much ground as he could legally under the Constitution but the other side is unreasonable. He would then call elections that he hopes to win by bringing back the moderate faction of the Socialist voter base under his fold. This may be the case, but we fear this is a static analysis.

In our opinion, Isabel Ayuso’s victory in May in many of Madrid’s red-belt constituencies is the most salient political development in Spain since the rise of Podemos and Vox. She ran on her Government’s relative economic success and decidedly business friendly policies. The PP’s national leader has learned the lesson and has surrounded himself with a team of neo-liberal economic advisors. Competence in economic matters prevailed in Madrid over the very poor initial record of the regional public health services. In fact, Madrid has the one of the highest CoVid mortality rates per population in Spain (5th out of 17 Regions). It would appear from the spectacularly poor Socialist and Podemos results in this and other regional elections, that Spanish voters are far more concerned about their economic future than they are about the real and present danger posed by Covid.

Thus, while the world zigs, Spain once again zags. The rise of populism seeded the current popularity of social democracy from California to Berlin. For many observers, this shift towards socialism is inevitable. It is the expected political reaction to widespread inequality following a period of great accumulation of wealth concentrated in a small number of individuals. Possibly the reason that Spain’s electorate will turn to the right of centre is that the country has largely missed that rising tide. In fact, the fortunes of Spain’s billionaires have been lacklustre as their companies and investments have underperformed global peers and benchmark indices for many years. Couple that with a shocking lack of new successful companies and the exponential rise of wealth seen in other lands is just a distant curiosity to Spaniards as it has been for centuries.

In addition, the financial fortunes of all other savers have suffered from high management fees and expenses, and the unusual continued popularity of value managers who have consistently underperformed broad indices for years. It is high time for domestic investors to look at the Total Expense Ratio of their portfolios including advisory fees and broaden the mandates for equities while liquidating fixed income exposure. The price to pay I to lose a small amount on cash balances until better opportunities arise. It also makes sense to relocate the custody of one’s savings to another EU jurisdiction with better economic and financial fundamentals, and sound legal security. Sanchez’s cabinet just passed an Emergency Law that will allow the Government to put in place capital controls if there are emergencies as grave as wide spread flooding or a blizzard. (We can provide some references for this issue).

Saving the summer tourism season is the immediate economic concern. While Germany has warned its citizens about travel to Spain, the UK has removed the confinement requirement for those who travel to Spain and have a vaccine certificate. Thus, the hordes of beer louts will retake Magaluf and Sitges, while British families will likely chose a different destination as their younger children will need to quarantine and who wants that burden coming back from one’s holidays! In the interim, the Delta variant will continue to spread until the Epsilon variant takes over, and so on. In the interim, it is important to check that you have developed immunity after receiving the vaccine because as many as 10% of the population does not, and to remember that the efficacy of any vaccine declines with age. Most people agree that Covid has accelerated many trends in business and brought forward many changes. We will see in time how long these trends last. Unfortunately, the one change that endemic Covid has brought is to reverse the decline of the percentage of death worldwide attributable to infectious diseases and possibly the continued increase in longevity of the past few decades may come to a lull for a while.

Newspapers are making as much of this new wave as they can, loyal to the motto “If it bleeds, it leads”. Even broadsheets such as the FT are not inure. The Guardian reports today that a woman died in Sydney’s delta outbreak. She was 90 years old. In an interview with Mary Daly of the Federal Reserve Bank of San Francisco on Friday, the FT reporter concluded, “top Federal Reserve official has warned the spread of the Delta coronavirus variant…poses a threat to the global recovery”. ” Mrs Daly does warn us that “one of the risks to our global growth going forward is that we prematurely declare victory on Covid”, but she does not mention the Delta variant once in the course of that interview. On the same issue, there is a second article: “How Delta variant forced Israel to rethink Covid strategy” which sounds quite alarming since most of the population has been vaccinated already. Yet, the director of Israel’s Infection Prevention and Control Centre concludes in the interview: “But the numbers of seriously ill are much lower [than previous waves] and it won’t collapse the health system. We have to be alert, not panicked or hysterical.” So much for reporting the news accurately and leaving opinions for that section. And, so it goes…

It is a rare occurrence nowadays for a politician to address a pressing problem candidly. Thus, when José Luis Escrivá, the Spanish Social Security Minister, stated the obvious in a TV interview, namely that baby boomers will have to work longer in return for smaller state pensions, all hell broke loose last week. Many left wing Spanish cabinet members live in a parallel universe where they pursue progressive policy goals with passion and utter disregard for fiscal targets. These inhabitants of a Sanchez sponsored Truman Show are not even remotely aware of the fiscal constraints enacted in the Maastricht Treaty, the Growth and Stability Pact, or the shotgun constitutional reform calling for a balanced budget which was imposed on Spain by its EU creditors before releasing any emergency funding in 2012. Certainly, none of these woke activists should be suspected of knowing that nine years later Spain has returned just €6,612 million out of the €41,333 million drawn out of the €100,000 million facility.

The allegedly secessionist parties that keep the Government afloat share this disaffection with the harsh realities of adult life. No sooner had the Catalan politicians and activists left prison thanks to a Presidential pardon, that they vigorously protested their undiminished intention to re-enact a referendum on independence, so much for atoning for their peccadillos. These politicians are wily but not very candid because actual independence, with all the responsibilities that true self-government entails, is the last thing they would ever want. How ca we be so blunt? Because polls in the Basque Country reveal the lowest support for independence in many decades. This is perhaps the case because the Basque Country has obtained self-rule in all areas of government (except for monetary policy as long as it remains in the euro). Most Basques are very happy with the current arrangement; and why shouldn’t they, as for now, they may have their cake and eat it too.

While Spanish politicians play highly choreographed Kabuki theatre scenes on the national stage, both on TV and in Parliament, they leave the actual hard work of pandemic control and economic recovery plans partly to regional governments and largely to fate. In spite of the rally in cyclical stocks, the economic prospects do not look particularly bright. Let’s not forget that many workers are still in furlough programs, bankruptcy courts are not taking new cases, and banks are not providing for restructured loans, at least for the time being. Out of sight, out of mind! When the Socialist Party ran against Rajoy’s Popular Party, their economic advisors had a plan. They shared the EU’s concerns on the very high structural rate of unemployment as well as the very large contribution to employment and economic activity from SMEs that are far too small to compete not only on the global stage but also within the EU. Such facts based concerns have evaporated from cabinet meetings.

Lack of scale and scope are a major handicap for Spanish businesses. There are very few, if any, truly multinational companies founded in Spain besides the Company of Jesus (and even in this case, technically, it was founded in Paris). The largest public companies’ market capitalizations have been getting smaller on a relative basis vs. global peers for two decades as their massive capital deployment in Latin America has proven to be a fatal strategic mistake as we expected. Their falling share prices have more than offset the massive increase in share count. There are no big pools of domestic savings investing in equity risk. In fact, there are no pools of domestic savings large enough to finance the non-financial private sector debt. As a result, Spain has a large and growing net international debtor position, which is likely close to 100% of GDP even before taking on the additional burden of the EU’s Next Generation Program.

Spain is a very low trust society and for good reason as graft and corruption are rampant and accountability a foreign concept. When you meet investors there, no matter how small their size, they all agree that they only like to make investments in companies where they can exert influence over strategic decisions and have voting control. Not surprisingly their returns suffer as this is a perfectly good example of an algorithm with a built in negative selection bias. For starters, it is hard for them to find any investment candidates outside of Spain, and when they do, it is usually not a great situation. This stubborn policy is in stark contrast with Warren Buffett’s investment strategy. Berkshire Hathaway is content with finding good companies at attractive valuations and let the management run the company on their behalf. Their emphasis is of course on the quality of the business model. As Mr Buffett famously quipped: “I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will”. Berkshire’s strategy has worked far better, even for the lacklustre last two decades, than any of the observable investment returns for Spanish investment companies or funds. Yet, the latter’s managers persevere in their blind faith on their apparently flawed model.

In a country where the private sector shows such idiosyncrasies, what should one expect from government directed investments? In our case, very little that may contribute to long-term productivity growth. In fact, productivity growth in Spain is extremely difficult as the contribution of services to GDP is very high. On a recent visit to the Basque Country, we discovered that self-rule is not a recipe for more enlightened rule either. We learned from a famous restaurant owner that because of a tax audit where the authorities could find no evidence of fraud, the inspectors nevertheless concluded that the restaurant’s employees were working far too many hours per week and sent their file to a labour inspector. Thus, this famous restaurant, perhaps one of the best fish and seafood restaurants in the world, will not be opening for dinner several days per week going forward. These luminaries are the same mandarins that will help Spanish politicians identify investment cases worthy of EU money. And so it goes…

In any case, until the mana from Brussels becomes available, the Government’s policy priorities are such important topics as passing a law that allows minors to choose their gender without parental consent. Indeed Spain is a country where one may choose one’s gender without changing one’s sex. Surprisingly, Spanish male citizens are not taking advantage of this gaping legal loophole. They should reconsider for two reasons. First and most importantly, it will put an end to a paradoxical and perhaps unconstitutional reverse discrimination situation built into the domestic violence prevention laws whereby male Spaniards bear the burden of proving their innocence when the plaintiff in such cases is female. Secondly, gender equality laws call for equal representation of women and men in Cabinet positions, seats in parliament, the civil service, and boardrooms. Thus for a male Spaniard to choose to become a female is a dominant strategy. The reverse is only true in the case of the King’s daughters. The eldest would ensure her status as the Crown Princess under any scenarios. Conversely, the second born would become the Crown-Prince as long as her older sister remains a woman, as the Spanish Constitution still gives priority in the line of succession to male over female heirs to the Crown.

The progressive visionaries in the Spanish government have economic policy initiatives such as a 30% increase of the minimum wage that has left most people under 30 unable to join the formal economy lately or resuming inflation indexing for state pensions when Social Security is already running a cash deficit of more than 1% of GDP. The reforms to public pensions will be disclosed to the general public over two years; nevertheless, the gist of it is what Mr Escrivá naively let out unwittingly, for pension sustainability is a demographic problem, not a political position. There might be a loss of consumer confidence as a result, which may or may not compromise the pace of recovery; perhaps these changes will have no effect. The Labour Minister, a Communist, has yet to make any pronouncements on the labour market reform, which is the second important point on the long list of conditions that comes with the EU’s funds. The local media do not seem to have Internet access and remain mute on this subject as well. Travel restrictions compromise the success of the summer tourism campaign and there is no 2022 Budget agreement in sight for now, as support in parliament is conditioned to the progress Sanchez will make in his discussions on devolution of powers with the head of the Catalan government. Other than that, it is all well in the best of all possible worlds until that is, any member of the Euro group decides it isn’t anymore. In the interim, the Truman Show will go into its 3rd season.