Some Thoughts on the Spanish Election

Spain went to the polls Sunday for the third time since 2015. The Socialist victory suggests that more expansionary fiscal policies will be followed, which in turn is slightly negative for Spanish bonds. The weaker euro should help Spain’s export sector, amongst the largest in the eurozone.

POLITICAL OUTLOOK

Former Prime Minister Pedro Sanchez looks set to lead the next government, albeit from a stronger position than before. The Socialists won 123 seats, up from 85 in the 2016 elections. Left-wing (and likely coalition partner) Podemos won 42 seats, down from 71 in 2016. But with 165 seats, these two would need the support of some smaller parties to form a governing coalition with 176 seats.

Podemos is a populist party that was only formed in 2014. It has quickly become a major player in Spanish politics, winning 69 seats in the 2015 elections and 71 in 2016 before falling to 42 this weekend. Still, it is a large enough coalition partner to exert pressure on the Socialists.

With the leftward lurch seen in Italy, many were concerned that Spain would go down the same path. While a more expansionary fiscal policy seems likely, we do not think the Socialists will be as confrontational as the Five Star/League coalition in Italy.

Indeed, the Socialists are doing their best to reassure markets. Senior economic advisor Manuel de la Rocha said “I want to send a firm and reassuring message to investors and markets: The economic policies will continue. Fiscal consolidation, macro-economic stability and reduction of inequalities and very pro-European policies will be the priorities for the next government.”

The right-wing parties did worse than expected. The new Vox won 24 seats and became the first far-right party to enter parliament since the advent of democracy (see A Brief History Lesson below). Vox’s support came at the expense of the right-wing Popular Party, which only won 66 seats compared to 135 previously.

The centrist Cuidadanos party tilted right on the issue of Catalan separatism. It ended up winning 57 seats vs. 32 previously. However, the decision of Cuidadanos leader Albert Rivera to throw his lot in with PP and Vox over the issue of Catalan separatism will keep the party out of the government.

 

A BRIEF HISTORY LESSON

Spain was ruled with an iron hand by Generalissimo Francisco Franco from 1939 until his death in 1975. He is still dead. In 1936, military officers launched a coup d’état against the civilian government of the so-called Second Republic. Franco was part of this group and rose to prominence during the ensuing Spanish Civil War, defeating the Republicans in 1939 with the aid of the Axis powers Germany and Italy.

Franco largely stayed out of World War II, though he clearly sided with his fascist allies in Europe. Spain sent volunteer troops to fight alongside German troops on the Russian front. Spanish ports were also used by German U-boats. After the war, Spain faced international isolation, but relations with the West improved as the Cold War unfolded. Spain allowed the US to construct several air and naval bases on its soil, in return for economic and military aid.

In 1969, Franco hand-picked Prince Juan Carlos to succeed him. He was the grandson of Alfonso XIII, the last king of Spain before the monarchy was abolished in 1931. He was groomed by Franco to be Spain’s next leader and was crowned King Juan Carlos two days after Franco’s death. The repression of Spanish society under Franco has been widely condemned, and rightfully so.

Yet rather than continue with Franco’s authoritarian rule, Juan Carlos immediately began to liberalize the political system. He dismissed Prime Minister Carlos Arias Navarro, a staunch supporter of Franco, and appointed Adolfo Suarez to his post. Political parties were legalized, and the first post-Franco elections were held in June 1977 and won by Suarez. A new constitution was promulgated in 1978 establishing Spain as a parliamentary democracy, with the king as the head of state and commander of the armed forces.

A military coup was attempted in February 1981. Parliament was seized by the plotters in the name of the king. When King Juan Carlos went on the air to declare his unambiguous support for the democratically elected government, the plot was foiled. Spain has never looked back.

In October 1982, the Socialist Party (PSOE) won 48% of the vote and 202 seats. Under the leadership of Felipe Gonzalez, the Socialists completed the post-Franco transition by overseeing legislation that further liberalized social freedoms and boosted education. During their 14-year rule, the Socialists also ushered Spain into the European Union in January 1986.

After a long run in power, a series of corruption scandals saw the Socialists eventually fall from grace. The June 1993 elections saw the Socialists lose absolute majorities in both houses of parliament. This led to an unstable period that led to early elections in March 1996. This vote saw the center-right Popular Party (PP) come into power, led by Jose Maria Aznar. After ruling in coalition for its first term, the PP won an absolute majority in parliament in the March 2000 elections.

Since the return of democracy, politics has been dominated by these two parties. The Socialists came back into power in March 2004, led by Jose Luis Rodriguez Zapatero. PP was widely expected to win then but was likely hurt by the Madrid train bombings that March. With 164 seats, the Socialists needed the support of two minor left-wing parties to rule as minority government. The Socialists won the March 2008 elections and increased its seats to 169 but still failed to win an outright majority.

Early elections in November 2011 saw the PP return to power with an absolute majority of 186 seats, led by Mariano Rajoy. The lingering impact of the financial crisis was likely the main reason for the poor showing by the Socialists, who lost 59 seats in a crushing defeat.

The next elections were held in December 2015. No clear winner emerged from the most fragmented parliament since the return of democracy. The PP lost 64 seats but still emerged as the largest party with 123, while the Socialists lost 20 seats but still came in second with 110. The big winners were Podemos (third with 69 seats) and Cuidadanos (fourth with 40 seats). Neither of the two major parties were able to form a coalition.

Another election had to be held in June 2016. Mariano Rajoy of the Popular Party became Prime Minister, helped in large part by the abstention of the opposition Socialist Party. He led a minority government that held only 137 seats in parliament, governing with the support of center-right party Cuidadanos (32 seats).

In May 2018, a court found that the Popular Party had engaged in illegal kickback schemes in the early 2000s. By June 2018, the opposition parties succeeded in passing a vote of no confidence, the first time this happened since the return of democracy. The Socialist Party led by Pedro Sanchez governed as a minority, with even less seats (85) in Parliament. When parliament failed to pass his budget in February, Sanchez called early elections and that’s how Spain ended up with its third election in four years.

 

ECONOMIC OUTLOOK

The economy is slowing but continues to outpace the rest of the eurozone. Spain is the fourth largest economy in the eurozone, coming in behind German, France, and Italy. Exports account for nearly 40% of GDP, making it very dependent on global growth and trade. By comparison, France is around 30%, Germany nearly 50%, and Italy also around 30%.

The IMF recently cut its 2019 growth forecast for Spain by a tick to 2.1% but kept its 2020 forecast steady at 1.9%. This compares to 2.6% growth in 2018. GDP rose 2.3 y/y in Q4, the slowest since Q4 2014. Q1 GDP data will be reported tomorrow, and growth is expected to remain steady at 2.3%. Monthly data was a bit soft and so we see some downside risks to Q1 growth.

Price pressures are still low. Headline inflation picked up to 1.3% y/y from 1.1% in February but remains near the cycle low of 1% in January. March data will be reported Tuesday and inflation is expected to accelerate to 1.5% y/y. Like much of the eurozone, Spain is struggling to achieve higher inflation.

The rejection of the 2019 budget proposal sparked these elections. With a stronger mandate, the center-left coalition should be able to pass a more expansionary budget. Even without the budget passing, the Socialists were still able to push through some popular measures. These include a hike in the minimum wage, improved unemployment benefits for older workers, and increased public hiring.

As a result, the budget outlook bears watching. The OECD sees the budget deficit narrowing from -2.5% of GDP last year to -1.8% this year and -1.2% in 2020. With growth expected to slow and the Socialists prepared to boost fiscal stimulus, we see upside risks to these deficit forecasts. In turn, this may get the attention of the ratings agencies.

The external accounts improved sharply during the downturn, but that has ended. The IMF sees the current account surplus narrowing from 2.6% of GDP last year to 2.1% this year and 1.9% in 2020. However, we see risks ahead as exports have been contracting y/y in dollar terms for the last four months. On the other hand, imports are likely to surge due to higher oil prices. These trends bear watching.

Spain’s Net International Investment Position has fallen to -78% of GDP. While this is the lowest since 2006, it’s still on the high side compared to other eurozone countries.

 

INVESTMENT OUTLOOK

The euro is underperforming after outperforming last year. In 2018, EUR fell -4.5% and was behind only best major performers JPY (+2.7%) and CHF (-0.8%). So far in 2019, EUR is -2.5% and ahead of only CHF (-3.7%) and SEK (-7%).

With the ECB expected to maintain its dovish stance and perhaps add more stimulus ahead, we believe the euro will continue to weaken. The single currency recently saw support near the $1.1120 area, corresponding to the June 2017 low. Break below that would target the May 2017 low near $1.0840 and then the April 2017 low near $1.0570. In turn, the weaker euro would help the more export-dependent economies in the eurozone like Spain.

Spanish equities are still underperforming. In 2018, MSCI Spain fell -16.4% compared to -11.6% for MSCI DM. So far in 2019, MSCI Spain is up 14.2% vs. 17.0% for MSCI DM. With the elections out of the way, we expect Spanish equities to stop underperforming so much, as suggested by the NEUTRAL weighting on Spain given by our DM Equity Allocation model.

Spanish bonds are outperforming. The yield on 10-year local currency government bonds is -40 bp YTD and is behind only the best DM performers Greece (-101 bp), Portugal (-59 bp), Australia (-53 bp), Israel (-49 bp), and New Zealand (-47 bp). With deficit spending expected to rise, we may see some downward pressure on Spanish bond prices that would lead to increased underperformance.

Our own sovereign ratings model shows Spain’s implied rating steady at BBB+/Baa1/BBB+. Actual ratings are A-/Baa1/A- and so our model is in line with Moody’s but slightly more pessimistic than both S&P and Fitch. Fitch recently wrote that “The main potential implications for Spain’s sovereign credit profile are how the election outcome affects fiscal policy and the path of public debt/GDP; and the impact of Catalonia-related tensions.”