Concern Shifts to Portugal

Markets have been oddly complacent about the lack of debt deal for Greece. Perhaps it's because a Greek default is a foregone conclusion with yields on the €14.4 billion in bonds due on March 20 hitting 1100% in late January. Investors are now shifting their attention to the next PIIGS (Portugal, Italy, Ireland, Greece and Spain) domino set to fall.

That domino is Portugal. The recent selloff in Portuguese bonds has sent yields and the cost of insuring the country's debts to record highs and to levels reminiscent of those in Greece last summer, preceding that country's first debt write-down deal.

This has prompted the European Central Bank to intervene heavily in the Portuguese bond market to control the contagion. To the ECB's credit, it's done so with some success. The yield on 10-year bonds this morning stood at 16.49%, below record highs of 17.4% reached on Monday. Today, there will be another test of Portugal's ability to raise short-term funds, as it attempts to sell €1.5 billion in treasury bills.

So why the sudden focus on Portugal?

Many investors say a Greek default would mean that Portugal would need another bailout -- or at least a Greek-style debt-restructuring with a minimum 30% haircut to bondholders. Of course, the Portuguese government is working hard to shore up investor sentiment. A speech by Finance Minister Vitor Gaspar at the London School of Economics that I'll be attending tonight is part of that effort.

Gaspar is likely to echo Prime Minister Pedro Passos Coelho's declaration that Portuguese bondholders will never face a Greek-style haircut on their investment. Unlike Greece, he'll point out that Portugal's level of debt is sustainable. Portugal also has time on its side. Its €9 billion debt falls due in September 2013, a seeming eternity from now.

The finance minister will also point out that government was able to meet its 2011 budget deficit targets. Under the terms of last summer's 78 billion euro bailout program, Portugal is expected to cut its budget deficit to 4.5% of GDP in 2012 and 3% by 2013, down from 9.8% in 2010. He'll probably gloss over the fact that 2011 targets were met thanks largely due to one-off measures transferring banks' pension to the social security system- a well-worn tactic of desperate governments across the world.

Finally, Gaspar will point out that the Portuguese government enjoys a majority in Parliament, allowing it to pass spending cuts to meet strict government spending goals more easily. And he'll boast that in contrast to Greece, Portugal has seen little social unrest. Unions and employers recently agreed to an extensive labor reform that will make layoffs and salary cuts easier. That's something no other Club Med country has been able to do.

But if I get a chance, I will ask him about two things the Portuguese government cannot control.

First, the government cannot control the rate of economic growth so crucial to the assumptions behind Portugal's austerity program. And the news on that front is not good. Since the bailout plan was agreed upon in June, estimates of the size of Portugal's economic growth rate have been revised down twice. In August, it was expected that the economy would contract by 1.7%. By the end of the year, that was revised to 3%. Today, Citigroup estimates Portugal's economy could contract by 5.8% in 2012. Those kinds of differences throw a real wrench in the works of any bailout plan.

Second, the government's best efforts cannot contain the impact of financial contagion. Although the ECB is trying to rein this in by buying up Portuguese bonds, and the Portuguese government is on a PR campaign to reassure investors, the yields on Portuguese debt confirm that investors are pushing the other way. Once financial contagion really kicks in, there's not much the ECB or the Portuguese government can really do.

The only straightforward way to play Portugal for U.S. investors is through Portugal Telecom (PT), which now boasts a monster 17.3% dividend yield. The chart confirms, however, that if there is textbook definition of a falling knife, I'd be reluctant to catch it. This will be a big winner one day, but not yet.

At the time of publication, Vardy had no positions in the stocks mentioned.