A Slowing Economy
The eurozone as a whole is going through a rough patch, mainly as a consequence of trade jitters which hit Germany and Italy – its two manufacturing power houses.
And Spain’s export-driven economy is highly dependent on demand remaining sustained in the rest of the eurozone, and especially in Germany.
Last week, the Bank of Spain released its 2019-2022 economic outlook, where it warned that “It is expected that, along the projection horizon, GDP growth will continue to show, as has been the case since mid-2017, a gradual slowdown path… due to smaller contributions by external and domestic demand alike to output growth.”
The report added that “Despite the relative strength of domestic demand, this variable is expected to lose momentum in the coming years,” and pointed to “a projected sharper increase in imports than in that of exports”.
The Bank of Spain – from what we understand – is also worried about complacency from policymakers, who, after a long season of austerity and structural reforms, are now pushing to adopt a more expansive fiscal stance.
And rightly so.
The 2020 budget – Spain has not approved one last year because Prime Minister Pedro Sanchez could not find a majority to pass it – is likely to be expansive, as the only potential government coalition on the table would put together the Socialist Party (PSOE) with the far-left and – perhaps – many regional parties.
On top of that, some of the labor reforms introduced by the center-right Popular Party as a result of the crisis are likely to be rolled back – even though not every analyst agrees on how these measures were actually contributed to Spain’s recent above-average economic expansion.
Turbulent Politics
After two consecutive elections in April and November 2019, PSOE leader Pedro Sanchez is still attempting to muster together a Parliamentary majority, for which – in the best case scenario – he would have to rely on regional, separatist parties at a time when voters outside Catalunya are hardening their positions against secessionist attempts.
If Sanchez doesn’t manage to form a government yet another snap election will follow – the third in less than a year – an event that markets are likely to punish.
And uncertainty won’t be the only issue for markets.
Last week, the European Court of Justice released a judgment that condemned Spain for not giving former Catalan leaders and now elected Members of the European Parliament Carles Puigdemont and Oriol Junqueras the opportunity to take their EU Parliament seats – to do so, they would have had to participate in a swearing ceremony in Madrid, but police would have arrested them as soon as they touched Spanish soil.
The judgment further polarized the political discourse in the country, with new calls of “Spexit” from the far-right party Vox – which is polling at 15% now, and could easily become Spain’s third largest party in the event of a snap election.
That is why Sanchez needs to thread carefully – he needs the backing of regional parties but can’t offer too much or he will become their hostage later on in the legislature.
Conclusion
Spain’s 10YR Bonos have been tremendous performers – on an absolute basis – for the past two years. And while they have historically traded at a discount compared to Italian BTPs, the trend inverted with Italy’s spring 2018 election and the rise to power of the so-called “populist parties.”
Currently, the 10YR Italy-Spain spread is currently around 100 basis points, a fairly large one, and while it also reflects Italy’s slower growth and higher debt, it is for the most part due to its traditionally unstable politics.
But most of these factors seem to be reversing instead, with Italy’s eurozone exit now definitely off the table (not even the so-called populists talk about it anymore), while Spain’s growth is projected to be slowing down in the near future and political risk is increasing (two elections in the past year, and no proper government in place still almost two months after the last vote).
And while one way to trade this is through Bund-Bonos spread, we believe the cross trade with BTPs offers higher returns, and a positive carry, in exchange for only a negligibly higher risk (our conviction is that Italy – especially once the Emilia Romagna elections – is going to enjoy a higher level of political stability).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
