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On December 21 the people of Catalonia go to the polls to elect a new regional government. There is a lot riding on the outcome, not just for Spain’s political system, but for the country’s economy and financial markets too.
Spanish Prime Minister Mariano Rajoy on October 27 dismissed the Catalan regional government, dissolved its parliament and called a snap election in a bid to bring an end to arguably the country’s worst political crisis since it embarked on the road to democracy in 1975.
The moves followed the Senate authorising Madrid to impose direct rule over the region after its leaders held a referendum on independence – which the Spanish government deemed illegal – at the start of the month.
According to Jose Luis Alzola of New York-based macroeconomic policy think tank Observatory Group, Rajoy has taken a big gamble in calling an election given the risk pro-independence parties retain their parliamentary majority.
There is a danger the government’s response to the crisis – there were violent clashes between the national police and protestors on the day of the referendum, and Madrid is cracking down hard on Catalonia’s political leaders – will boost support for independence. It seems likely a sizeable number of Catalans who were previously ambivalent now believe the region should go its separate way from a country that won’t even allow it a vote on secession.
Companies shifting HQs
On the other hand, more moderate voters may be swayed the opposite way for fear of wreaking significant economic damage on the region. Since the crisis erupted more than 2,000 companies, including Catalonia’s biggest bank, have shifted their legal headquarters to guard against the risk of the region leaving both the European Union and the euro zone. 1, 2
For now, opinion polls suggest the election will serve up a similar outcome to September 2015 when pro-independence parties secured 47.8 per cent of the vote and took 72 of the regional parliament’s 135 seats. The same three parties are currently polling at around 46.7 per cent, with their unionist rivals not far behind on 43.5 per cent. 3
Alzola believes if the pro-independence parties were to lose their majority, the current standoff between Madrid and Catalonia will have ended for at least several years and any progress towards devolution will be slow. On the other hand, if they were to retain control of parliament, tensions will persist and Madrid may have to start negotiating with the region’s government with a view to meeting some of its demands. Even if the separatists were to lose power, it is likely Spain will eventually be forced to cede more control to the Catalan region, including ample tax-raising capabilities, which may require reform of the constitution.
Rajoy’s centre-right Popular party (PP) has traditionally rejected constitutional reform, while the Citizens party, which the coalition government relies upon for support, is even more vehemently opposed to the idea. However, the opposition Socialist party recently managed to extract a promise from Rajoy to debate proposals in parliament that would accommodate some of the Catalan demands. Other smaller parties also favour constitutional reform.
Support for independence, while far from a new phenomenon, has been on the rise ever since successive PP governments between 1996 and 2004 took steps to halt devolution. A subsequent attempt to enshrine greater Catalan autonomy in legislation in 2006 was challenged by the PP and brought to Spain’s Supreme Court.
Its judgment in June 2010 struck down key elements of the autonomy measures and served to magnify Catalan grievances, which by that time were starting to be inflamed by Spain’s economic crisis. That resentment has intensified in recent years, with the wealthy Barcelona region increasingly seeing itself as propping up poorer parts of the country.
According to Stewart Robertson, senior economist at Aviva Investors, while Spain is on track to extend a four-year recovery with growth of at least three per cent this year, the outlook would likely be for weaker growth in 2018, potentially significantly if the pro-independence parties were to retain their majority on December 21 as seems distinctly possible.
He says such a result would require some form of negotiation between Madrid and Catalonia. Any signs Catalonia was pushing for full independence would alarm financial markets, not least as it would raise questions over the division of Spain’s liabilities.
However, he thinks such a possibility remains “fairly remote” and it is much more likely the two sides would reach some form of compromise with greater autonomy being handed to Catalonia.
“Spain took quite a lot of powers away in 2010, and you suspect by returning these it would go a long way towards defusing the situation,” Robertson says. However, he adds that even in this event it is likely there would be elevated uncertainty for “at least a year or two” since the talks would likely be protracted.
To date, Spain’s financial markets have reacted calmly to the developments. For instance, the benchmark Ibex 35 stock index fell four per cent in the immediate aftermath of the crisis in late September, as investors fled what they perceived to be riskier Spanish investments. The index has since clawed back around three quarters of that loss as a degree of calm returned.4
Nonetheless, Frédéric Guignard, European equity fund manager at Aviva Investors, believes Spanish equities could be in for a bumpy ride in the coming weeks.
While he is unlikely to take positions in anticipation of the election’s outcome, Guignard believes an adverse result could spell trouble for shares in smaller companies that tend to be more driven by the domestic economy. From a sector perspective, shares in smaller regional banks doing business in Catalonia, as well as real estate and construction companies, could all be impacted.
On the other hand, any wider sell-off could throw up opportunities to pick up shares in large internationally-focused companies at a discount.
Meanwhile, bond markets initially fell, with the differential between German and Spanish ten-year government bond yields rising from 114 basis points on September 29 to 133 basis points on October 4. However, Spanish bonds have since recovered too, with the yield spread standing at 118 basis points, as of December 13.5
Bonds bet against breakaway
Geoffroy Lenoir, Aviva Investors’ head of euro sovereign rates, shares the market’s view that there is a low probability that Catalonia will break away from Spain. Although he believes Spanish bonds offer little value at present, this has less to do with the forthcoming vote in Catalonia than the threat posed by Italy, which is due to hold a national election early next year. With the anti-establishment 5-Star Movement currently topping the polls, Lenoir believes ‘peripheral’ European bond markets look vulnerable.
“While Catalonia breaking away from Spain could have major implications, it is difficult to see that happening. If the election is to have an effect on the market, it is probably more likely to come indirectly via its impact on economic growth,” he explains.
Although Robertson is not revising his economic forecasts at this stage, his growth estimates may be cut in the coming weeks depending on the outcome of the election. He points to a recent note from Oxford Economics in which it outlined a scenario whereby ongoing political uncertainty could subtract as much as 1.5 per cent, or €17 billion, from Spanish GDP by the end of 2019. Robertson believes a hit of this magnitude is entirely plausible.6
The analysis assumed dips in consumer and business sentiment of a similar magnitude to that seen in the first half of 2016 when Spain struggled to form a government. Oxford Economics assumes fixed investment is hit by both increased uncertainty and tighter financial conditions as Spanish government bond yields rise by 50 basis points. Meanwhile, household spending is adversely affected by a wealth effect with Spanish equity prices assumed to be ten per cent below where they would otherwise be.
Esteban González Pons, who leads the PP’s delegation to the European Parliament, recently claimed letting Spain break up with Catalonia risked leading to a domino effect across the continent. “Instead of a Europe of 27, we will have a non-Europe of mini-states.”
While such remarks are overly alarmist, according to Robertson, investors would be wise not to ignore the risks posed by the forthcoming election entirely.
4 Source: Thomson Reuters
5 Source: Bloomberg
6 Research note by Ángel Talavera, published Nov 21 2017
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 14 December 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.