Webmill, you have a truly distorted view of the Spanish situation at the time.
The Spanish Army consisted of about 20 infantry divisions. Artillery was both old and light. Tanks were few (about 200, grossly speaking), and the best model was the Soviet T-26. Anti-aircraft and anti-tank artillery were in very bad shape. The Navy was a joke. And the Air Force was mainly based on the Italian CR.32 fighter. The country could not produce modern heavy equipment, and was having problems to feed its people. So let's go point by point:
Particulary a Spanish Navy that could be built up by the Germans or Italians.
The Germans would have not only to built up the Spanish Navy, but also the Army and the Air Force, something that could not be achieved. It would be specially difficult in the case of the Navy, as capital ships took long time to be built. The "Imperial Plan" made by Spain in 1939 to rebuild its Navy asked for only four battleships, and was to last eleven years, so how many years would Spain need to build a Navy that could be considered a danger to the US? Even more so if you considered that nothing came out of the "Imperial Plan" because the country was utterly unable to build anything bigger that a destroyer, and even that with difficulty.
the US dilemna, in my assessment, was to risk casualties now in 1940 by interfering in Spain or take the US casualties later in say 1944 when Spains Facist-militaristic regime decides to strike at the US. The US does not want to face a Spanish militaristic regime bent on hostility, using the overseas possessions as the point, with a crippled Great Britain due to the loss of Gibraltar.
Exactly what were these overseas possessions? Guinea is out of the question, because there were almost no Spanish troops there and it could be easily cut off from Spain; the Canary Islands would be lost as soon as Spain declares war on Great Britain (the British had plans and troops earmarked for such a case); and Spanish Morocco adds nothing that could not be done from Spain. So what are you talking about?
And of course, the loss of Gibraltar would be far from a crippling point to Great Britain. In fact they had planned for just such eventuality, and be sure that they not considered it that way.
I would estimate the US real anxiety was that Spain would want to revenge their naval losses to the US Navy at the battle of Santiago Bay etc. And the US would not know where,when or how a Militaristic and hostile Spain was going to do this
Any Spanish regimen that could colaborated with the Axis would be far more interested in retaking Gibraltar, fighting the Soviet Union or gaining a colonial empire in Africa than in revenging the 1898 war. You are far overestimating the importance of the Spanish-American War in the Spanish psyche by that date.
A confrontation over Puetro Rico/Cuba is not out of the question for example;
And exactly how are the Spanish forces supposed to reach Puerto Rico and Cuba? Swimming?
"hardly a threat to anybody outside their borders (Spain)" Do you really think so?Other Axis forces fought well when teamed up with a German Panzer divsion; such as the more highly regarded Romanian Gebrig Div in Army group A in the Caucasus in 1942. true also of the Italian Ariete Div fighting along in DAK in N. Africa. Hungarian Divisions fought tough in late 1944 again along side German divisions after Romania defected .
Yes, hardly a threat to anybody outside the Spanish borders. Spanish military might in the 40's could perhaps achieve a victory over Portugal and Andorra, or even over Ireland if they could somehow reach that country, or at most take Gibraltar by its own. More than that is just a dream. Romanian and Italian Armed Forces were both bigger and in far better shape than Spanish forces. Also, for the first years of the war, both Romania and Italy were relatively safe from Allied attacks, while Spain would be open to such operation from the same moment it enters the war, so Spanish forces would be badly needed to defend Spain itself. Not much would be left to be sent "outside the borders".
I would say don't make the mistake of using poorly armed Axis troops in terms of anti tank guns to hold front lines when facing intact Allied/Soviet Armored Divisions..But the German Command was aware of Axis divisions weakness of anti tank gun capability.(although they broke the rule at the Don '42.)
So if you do not want the Spanish forces to hold front lines, what do you want them for? Ocuppation duties? They would be needed to garrison Spain, anyway.
The US was not completely aware how seriously weak the Axis foces (including a newly joined Spain) was in anti tank gun pieces as far as being their semi-permanent state of affairs as the war progressed, in my estimation.
The Allies were very aware of the weaknesses of Spain. The equipment was what was left from the Civil war and that was very well known. The US was very well informed about the dangerous situations regarding oil supply, as it was almost the only supplier. Spying was also providing good information to the British. For example, their estimations of the forces in the Canary Islands (that they made for their invasion plans) was fairly accurate. And the planning of Operation Backbone had very good information about Spanish forces and defenses in Spanish Morocco.
So to do a quick summary:
1) Spain in the Axis camp would be more a liability that an advantage for German unless the Soviet Union is defeated (or the war with the Soviet Union is somehow prevented) and Germany could use all its power against the British. In a sense, Spain joining the war along the Axis after the Fall of France would nor reinforce, but weaken, the German situation.
2) With a two-front war and the bulk of the German resources used in the East, Spain would be indefensible against the US.
3) The US knew very well the Spanish situation, and just the entrance of Spain in the war along the Axis would not be enough to force the US to fight.