Summary:
- Price of Spanish and German stocks indices at historically large divergence
- Catalan independence fallout weighing on the SPA35; DE30 near all-time high
- Bond markets suggest divergence may be overdone
The leading stock index in Madrid has fallen lower once more this morning, trading briefly down to its lowest level in a month (The DE30 is closed due to a German bank holiday but ended Monday within 50 points of its all-time high). The recent weakness comes from the constitutional crisis that is occurring in Spain at the moment following the overwhelming victory for Catalan independence in Sunday’s referendum. The referendum itself has not been recognised by the government in Madrid and this leaves the many unsure as to what the outcome will be.
The SPA35 has come under pressure following the Catalan independence vote last Sunday. Source: xStation
Catalonia is a relatively prosperous region in the north-east of Spain, and with a GDP approximately equal to that of Portugal, a secession would clearly be a major blow to the Spanish economy. Along these lines it’s not hard to see why there’s been some weakness in the Spanish stock market, with the IBEX (SPA35 on xStation) selling throughout the week. Having said that, the selling itself has been relatively contained and a far cry from the pandemonium seen in UK stocks following the Brexit vote last summer.
The reason for this relative calm is likely that many are still skeptical as to whether Catalonia will indeed achieve independence, and whilst the weekend’s developments – and in particular the shocking police brutality shown around the globe in trying to prevent voters from casting their ballots – have increased the likelihood of secession, this outcome remains far from certain.
Therefore there is a case to be made for the recent weakness providing a potentially attractive buying opportunity in the SPA35. One of our Q4 trade ideas (here) was in fact a spread consisting of a long position in the SPA35 with a short position of equivalent size in the DE30. One of the main reasons for this trade idea was the large divergence seen in leading stock market valuations in Madrid and Frankfurt , with the latter close to all-time highs whilst the former lags behind.
There is a large divergence between the DE30 and SPA35 at present. Source: xStation
Given the most recent events some divergence may be expected, but it could be argued that this spread is far too large considering the fundamental backdrop. Around a month ago the market began to follow different trajectories as the DE30 took off ahead of the German elections whilst the SPA35 meandered and traded little changed. Given that the outcome of the German elections was far from the most favourable from a market perspective (Merkel lost some of her majority, the far-right AFD gained more than 10% and the green party did well which could hinder auto stocks going forward) and as the country the continues to try and form a coalition government political backdrop is uncertain to say the least.
Add in the likelihood of ECB tightening in the form of either reducing or eliminating further QE purchases in the next 12 months and the potential for further Euro appreciation which weighs heavily on German exporters and it is not hard to make a case against a breakaway rally in the DE30.
Let’s now look at the relative yield spreads on government bonds and compare this to the spread seen in the relative indices (IBEX/Dax). Unsurprisingly there has been a rise in the 10-year yield spread between Spanish and German bonds, but there ratio here remains well below the levels seen earlier this year. A spread of 1.25% is around the highs of the last 2 months, but markedly lower than the 1.50% seen back in February and April.
The 10-year yield spread between Spain and Germany doesn’t support the large divergence in the respective stock markets. Source: Bloomberg
This means that investors in Spanish bonds are requiring a greater risk premium than those buying the German equivalent – as you’d expect given the recent news and relative strength of the economies. However the premium is less than that required earlier this year and far from elevated compared to the past 12 months.
Working on the assumption that the premium should exhibit an inverse correlation with the spread on Spanish and German stocks (a higher risk premium for Spanish bonds would equate to a greater discount needed to hold Spanish equities) then there is a marked divergence.
This is far from an exact science but the yield spread would indicate a DE30/SPA35 spread of around 2000 points compared to the 2700+ currently seen. This divergence obviously doesn’t have to close purely from the indices perspective as yields could well move apart further, but it could be said that the current yield spread appears to not support the size of the divergence in indices.