The Strategist

How to make money on the Catalonia crisis

10/12/2017 - 10:55

When financial markets resumed work after the weekend, the Spanish stock indexes declined, the yield of sovereign securities rose, and the euro fell against the dollar (EUR/USD). Investors feared that the referendum on the independence of Catalonia could lead to the disintegration of Spain. Their concerns are justified, but the crisis seems overblown and therefore offers several attractive investment opportunities.

Catalonia accounts for approximately 16% of the country's population and more than 20% of its gross domestic product. About a quarter of Spanish exports are produced in the region, and about the same proportion of foreign investment is sent to it. Barcelona, the autonomy’s capital, is not only a major European city, but also an important tourist center.

The division of Spain will reduce the country’s ability to service the public debt and will lead to a fall in the sovereign rating. In turn, investors will need to revise the target yield of government securities taking into account the increased risk. Also, it would be better to re-assess the potential of Spanish companies, which will have to deal with the domestic market of a smaller size. What is happening in Catalonia does not remain only within its borders. If the region successfully regains independence from Spain, Scotland and Flanders can follow it. The European Union has already faced separatist sentiment.

But the events in Catalonia can be a boon to investors. In the case of Spain, there are favorable opportunities both in the short and medium term. The European bond markets reacted to the results of the referendum and the irreconcilable position of Madrid with expansion of the yield spread between Spanish and German 10-year securities (the latter are considered a measure of risk-free yield in Europe). The gap jumped from 114 b. on September 29 to a maximum of 133 b. on October 4, and is still at a high level.

None of the EU countries advocated autonomy, and the Mariano Rajoy’s government resolutely rejected any negotiations with the separatists. The risk of withdrawing funds from deposits in Catalan banks and the withdrawal of companies weakens resolve of the autonomy government. The Spanish government has already taken steps to simplify the withdrawal of companies and banks from the rebel region, thereby exerting additional pressure on it.

In addition, Madrid can take advantage of the 115th article of the Constitution of the country and deprive Catalonia of its autonomous status. All this speaks in favor of the indivisibility of Spain, although the tension in the north-eastern region will persist. The value of the bonds will probably depend on the success of the Spanish government. Prices for financial assets indicate that the peak of the tension of investors has already passed. The ECB will continue to buy sovereign securities within the stimulus program in the foreseeable future. In these conditions, the yield of Spanish short-dated bonds may fall even lower, and the spread with German bonds will decrease. But that's not all. The Spanish authorities are carrying out large-scale reforms to clean up the banking system after the collapse of housing prices due to the financial crisis, and in light of the threat of separation of Catalonia, they can accelerate. Also, additional measures should be expected to attract direct investments into the country in order to compensate for the negative consequences of the Catalan referendum. For example, tax deductions and the conversion of debt into equity are often used to attract investment.

In general, the situation in Catalonia can be nothing more than a tempest in the tea cup, but with excellent opportunities for investors in stocks and bonds.