Spain: The Market's Darling

We argue that part of the euro's rise over the past several months reflects a reassessment of Spain's outlook.  Many global investors had been under-weight Europe though most of H1 13, favoring the US and Japanese equities.  However, as the PMIs began indicating an economic recovery, foreign investors moved back into Europe.  

Some hedge funds made a big splash moving into Greek banks and bonds, among the most distressed assets.  For many real money accounts, Greece was still too much of a risk and lacked sufficient liquidity.  On the opposite side of the spectrum, expected returns from Germany were seen limited.  This underscored the attractiveness of Spain and Italy. The former appears to have implemented more structural reforms, though the IMF and OECD are pressing for it to extend the labor market reforms, than Italy.  Unit labor costs, for example, have fallen in Spain, but not so much in Italy, which speaks to the relative competitiveness.  

The demand for Spanish bonds reached new heights yesterday.  The Spanish government sold its largest issue,  10 bln euros of a new 10-year bond through a syndication of banks.  There were some 400 bidders who together wanted to buy 40 bln euros worth of the issue.  Both appear to be records.  Initially, the bond was priced 185 bp on top of mid-swap rates and due to demand was lowered to 178 bp.   The bond has a 3.8% coupon. 

Spain's 10-year bond yield briefly traded below 3.65% earlier this week.  It was the lowest yield since 2006 and was last seen when all three major credit agencies gave Spain a triple-A rating.  Although the rating agencies are often criticized for being laggards, an important shift took place last November, when first Fitch and then the others revised Spain's outlook to stable from negative.  This was understood by many institutional investors as reducing the risk that Spain would lose its investment grade status and helped pave the way for the subsequent buying spree. 

Spain's premium over German continues to narrow.   It has already come in another 18 bp so far this year.   At around 200 bp it is a third smaller than six months ago.  Many participants are looking for the Spanish premium to fall toward 150 bp in the coming months. 

There are two developments today to note.  First, the Bank of Spain estimated that Q4 GDP rose 0.3% after a 0.1% rise in Q3.  The official report is due next week (January 30), but the central bank's estimate is usually fairly good.  Of particular interest, household demand appears to have increased by 0.4%, for the second consecutive quarter. Not so good, both imports and exports fell by about 0.6%.  

Separately, it was reported that Spain's unemployment rate ticked up in Q4 to 26.03% from 25.98% in Q3 on a seasonally adjusted basis.   Spain's workforce shrank by 65k to 16.78 mln.  This is the lowest level since 2008.  This reflects  people giving up job hunting, or just as likely, left the country to work elsewhere.  The number out of work fell for the third consecutive quarter and for the first quarter since Q1 2008, the number of employed increased.  Recall that the December composite PMI also showed the employment reading at five year highs.  

Yesterday's Spanish bond auction can also be placed within a larger context of well received peripheral sovereign bond auctions this year.  Ireland had returned to the capital markets in a big way selling 14 bln euros of a 10-year bond earlier this month.  Portugal raised 11 bln euros by selling a 5-year bond.   

Portugal is playing a bit of catch-up and investors have become more optimistic about its ability to exit the aid programs later this year.  Portugal's 10-year yield is off 83 bp already this year, more than double Spain's yield decline and four-times large than the decline in Italy's 10-year yield.  Given the spread compression elsewhere, some fund mangers see the juicy Portuguese yields of more than 5% as offering reasonable value.   Portugal's out performance does not extend to the short end, where 2-year yields are essential flat this year, while Italy's 2-year yield is off 14 bp and Spain's is off 31 bp. 

Turning to equity markets, Italy's FTSE MIB Index is the best in the G7 thus far this year, rising 5.7%.  Portugal's Stock Index (PSI General) is up about 4.75%, while the Spain's IBEX is up 3.75%.  The Dow Jones Stoxx 600 is up 2.2% year-to-date.  Separately, we note that the equity theme evident last year, by which the small caps out perform large caps appears to be carrying over to this year's activity.  This is evident in the UK and France (and Japan and China), though less so in German, Italy and Spain (and the US).   

Some observers have suggested that a potential spanner in the works could be Greece, where its primary surplus could embolden its negotiators.  In turn, it is anticipated that Greek tensions could again spill over and hit other peripheral bond markets.  The risk of default would appear to increase with the primary surplus.  Yet,  with the  past restructuring of its private sector debt, which took place before a primary surplus was reached,  the majority of Greek debt is in official hands.  

We argue that this ownership of the debt matters.  The official sector includes the ECB, a number of countries, and other European official entities, alongside the IMF.    The way we see the historical precedent is not to default to the official sector, but for the official sector to lengthen maturities and reduce interest rates.   Some European officials, including from Germany, have suggested sympathy for this latter route provided Greece continues with its efforts.