Prospects are for Spain to remain intact even as discontent simmers.
When financial markets opened Oct. 2, Spanish equities were down, sovereign yields were up, and the euro weakened significantly against the dollar, as investors worried that the push for secession in Catalonia could lead to a breakup of Spain.
The concern is justified, but the crisis may also be overblown and could offer investment opportunities.
Catalonia accounts for about 16 percent of the country’s population, and more than 20 percent of gross domestic product. About a quarter of Spanish exports are Catalan products, and about the same proportion of inward foreign investments to Spain is destined to the region. Barcelona, the regional capital, is a major European city and remains an important tourist draw.
A truncated Spain could lower the country’s debt service capacity, causing rating firms to downgrade the obligations. Investors, in turn, would have to re-evaluate risk-adjusted returns in holding sovereign paper, and reassess the earnings potential of Spanish companies that would have to deal with a smaller domestic market.
What happens in Catalonia doesn’t just stay in Catalonia. If the region successfully gains independence from Spain, that could, for example, encourage Scotland’s efforts to secede from the U.K., and the Flemish separatist movement in Belgium. A European Union that is already struggling to become a unified economic region could, instead, become more splintered, reducing prospects for its economy and markets.
But the Catalonia developments could also be a boon for investors. In the case of Spain, the opportunities exist both in the short and medium terms. European bond markets reacted to the referendum result and the intense Spanish clampdown on protests by widening the spread between the yields on Spanish and German 10-year sovereign obligations, the latter being Europe’s measure of “risk-free” return. The gap rose quickly from 114 basis points on Sept. 29 to a high of 133 basis points on Oct. 4, and still remained elevated at 122 basis points on Oct. 9 (chart below).
With no European Union government providing even verbal support for the Catalan movement, and the government of Prime Minister Mariano Rajoy resolutely opposed to discussions with the separatists, prospects are for Spain to remain intact even though discontent will continue to simmer in the northeastern region. The threat that bank deposits may flee Catalonia-based banks, and that companies would leave, are also expected to weaken the Catalan resolve to secede. The Spanish government has already taken steps to make it easier for companies and banks to move from Catalonia, putting even more pressure on the region. Spain also holds the threat of using Article 155 of the country’s constitution to cancel Catalonia’s autonomy.
Bond markets will likely reflect the relief of investors as the Spanish government succeeds. Some comfort has already come through in financial asset prices. Also, with the European Central Bank expected to continue its bond purchase program for the foreseeable future, Spanish debt yields may decline further and the spread with German obligations could tighten.
That may not be the end of the positive story for investors. Spanish authorities have made significant reforms in cleaning up the banking system after the collapse of property prices during the financial crisis, and this could be sped up in light of the Catalonia threat. Furthermore, expect new measures to attract direct investments into Spain to offset the adverse impact of the Catalan vote. For example, tax incentives and opportunities for converting debt into equity are often-used measures to promote investments.
In sum, the Catalonia situation may just be a storm in a teacup, but it’s one with important implications for both bond and equity investors.