We expect Catalonia to stop short of winning full independence, but not in any great hurry.
Price action in global fixed income markets was relatively subdued over the course of the past week. Strong ISM data reaffirmed the continued health of the US economy, though for the time being it seems that speculation surrounding the identity of the next Federal Reserve (Fed) chair is gathering greater attention on the part of investors. White House comments suggest clarity on this matter should be forthcoming in the next couple of weeks and for the time being, potential candidates are being scrutinised with their respective hawkish or dovish credentials. We are inclined to believe that Trump will favour a candidate who favours deregulation and an individual who he feels he is able to influence in office. This could make the reappointment of Janet Yellen less than likely in our view and we are inclined to look at the current field of alternative candidates as being perceived as less dovish than the incumbent Fed chair, as things currently stand. For example, the appointment of Kevin Warsh could see yields rise up to 20bps in our view, though ultimately we would stress that it is the path of economic fundamentals more than the personality of the next chair, which will ultimately determine the trajectory of rates in the months to come.
In Europe, the principal focus in the past week was the independence ‘referendum’ in Catalonia. Heavy handed tactics from the Spanish government seeking to ban the vote made for some unpleasant TV viewing last weekend and may have gifted something of a victory to the separatists. However, we do not see a realistic path to a ‘Catalexit’ and continue to believe that the eventual outcome will be for negotiations which lead to increased autonomy for Catalonia within the nation of Spain. It should be emphasised that the Spanish constitution does not allow for independence referendums to take place. Furthermore, polls suggest only around 40% of the Catalan population really wants independence and less than half of voters in the region voted for separatist parties in the last election. The vote last weekend saw widespread instances of voter fraud – with some boasting on social media of their ability to vote 10 or more times at different polling stations within their locality. Clearly many were also unable to vote and some ballot boxes were seized, though ultimately the point here is that the 1 October referendum carries no legal weight and even if the regional administration unilaterally declares independence, they are aware that Madrid will not tolerate this and will dismiss the regional administration triggering fresh elections.
In this context, pro-independence parties may hope for confrontation and sympathy to boost their vote share, yet the whole Catalan question is probably going nowhere in any great hurry. Ultimately, there will be a need for dialogue, but so entrenched is Mariano Rajoy, this will probably require a change in the national government first (something that could come about if new elections are required without a majority to pass a Budget). We see the Basque region as a template for what the future may hold for Catalonia. Nationalistic passions have always been strong in Pais Vasco, but the region remains within the union of Spain – albeit enjoying increased autonomy and control over fiscal revenues than is enjoyed by the other Spanish regions. Over time we expect Catalonia to win a similar deal, but to stop short of full independence, which could see the region voting to leave the EU and the euro and mired in a messy divorce, which would make Brexit look like a walk in the park. If that weren’t bad enough, the mere prospect of Barcelona being ejected from La Liga could really be the final straw and consequently such an end-game seems pretty far-fetched in our view. Consequently, we see an opportunity in buying debt from the region and with spreads north of 400bps on offer, take the view that Spain will continue to honour the debts of its regions.
Events in Spain weighed on the periphery during the past week and also saw some euro corporate credit spreads slightly wider. By contrast US corporate spreads rallied on solid investor demand, helped by last months’ rise in overall yields. More broadly speaking, other markets were more or less range bound, with volatility also subdued thanks to holidays in China. EU comments suggested that Brexit talks remain at an impasse, but with a wounded Theresa May limping (or coughing) her way through the Conservative Party conference, there is no immediate catalyst for fresh UK moves even if the ticking of the Brexit clock is growing louder all the time. Across the Atlantic, the prospect of a default in Puerto Rico may come as a concern to municipal bond investors, but beyond this market seems to hold little wider significance.
Looking ahead, the monthly payrolls report is just around the corner. However, hurricane distortions may make this report more difficult to assess than normal and, therefore, a downside surprise is unlikely to detract materially from the constructive view we maintain on the economy. Consequently, further range trading may be possible in the days ahead and with VIX dropping to its historic lows, it may be necessary to get more clarity on topics such as tax reform or the identity of the next Fed chair before fixed income and currencies move more decisively. Otherwise, the next few days in the UK should generate some interesting headlines. We are inclined to believe that the next round of Brexit negotiations are likely to end in impasse and fears re-surfacing with respect to a hard Brexit. Meanwhile, speculation regarding the future of Theresa May would seem to make her position untenable, if it weren’t for the lack of an obvious replacement. It seems like the government finds itself in something of a beastly situation.
Mark Dowding, co-head of Investment Grade at BlueBay Asset Management