The year of politics is not quite over…
Thoughts on Catalonia
Last week, in one of our daily morning team meetings (when all the economists, strategists and fund managers gather round to exchange market-relevant news and views), each and every one of the contributions was about politics; including Brexit, Germany, Italy, Catalonia, the Netherlands, the US and Japan.
2017 had long been in my calendar as the year that politics would dominate; it’s the first time since 2002 that French and German elections have coincided*. But when I first realised this a few years ago, little did I know that the Brexit rollercoaster would have even existed, never mind being such a white-knuckle ride. Or that a snap UK election would be called.**
By and large the risks for investors that we’ve been highlighting have not crystallised. For example, Marine Le Pen did not become French President, the far-right party in the Netherlands has not formed a government, and the share of the vote the AfD party achieved is not enough for it to wield any meaningful power in Germany. But one thing we were not anticipating was the constitutional crisis in Spain.
So what is our view on Catalonia?
The current escalation is seen as temporary, and ultimately we don't think Catalonia will get independence in any meaningful timeframe. Although the heavy-handed government tactics are likely to have driven up support, the 40% turnout numbers are probably lower than what would have been without the violence.
The majority of the Catalonians and even the majority of the current regional government are pro-European, so the threat that they will lose EU status is meaningful leverage. Furthermore, the threat of Catalan banks being cut off from ECB funding is there too.
Even if the Catalan leader makes the unilateral declaration of independence, they do not have enough fiscal resources to make independence work without support from Madrid. Indeed, the news that Catalan banks and other companies are moving their headquarters out of the region is blow to the feasibility of an independent state.
The central government has threatened to trigger the National Security Law or Article 155 of the Spanish Constitution which allows Madrid to take control of an autonomous region. This could heighten tensions and almost certainly lead to a new regional election and potentially a new expression of desire for independence.
But there are still many legal hurdles that would need to be overcome for Catalonia to become independent, and these do not look easy to clear. For example, even if an official referendum was granted, this would be nation-wide and the chances of a pro-independence outcome are slim.
The most likely outcome is further fiscal autonomy (and therefore keeping more of the Catalan revenues for itself) like the Basque region has (and this is already on the negotiating table). As Catalonia is one of the biggest net contributors to the fiscal system, this will affect the redistribution between the regions, so either less money for the other regions or Spain has to run a bigger deficit.
Overall, we do not see the Catalonia situation being a systemic risk for the rest of the euro area and it does not add to euro area break-up risk. It seems markets agree with us; so far the sell-off has been relatively muted (indeed an investor who had purchased the 2020 bond back in December 2016 would still be up on an absolute-return basis versus holding the cash in euros). But should we see a large sell-off in Catalonia bonds, this has the potential to be a buying opportunity as the default risk seems low to us.
How quickly the issue in Catalonia gets resolved will become clearer in the next week or so, with the Catalan leaders clarifying their stance and giving an indication of whether new elections will take place. So it seems this year’s ups and downs are not yet over. Maybe 2018 will be a bit quieter with Italy being the only major country to have elections…but I would not want to jinx it.
*Should usually occur once every 20 years as France is on a five-year cycle and Germany every four years.
**The geek in me is compelled to let you know that it’s the first time all three of these countries have had elections in the same year since 1924.