The Daily Update - Portugal upgrade and potential 'Cexit'

S&P upgraded its rating for Portugal's sovereign debt from sub-investment grade, to BBB-. The rating agency previously moved Portugal's rating to junk back in 2012 after the country received a EUR 78bn bailout package in 2011, as it was unable to sustain its massive debt load. S&P cited the ‘solid progress (Portugal) has made in reducing its budget deficit and the receded risk of a market deterioration in external financing conditions’ as the reason for the upgrade. Moody’s and Fitch maintain Portugal’s long-term rating at junk.

Portugal’s economy has improved, alongside the broader EU; latest figures show that unemployment stands at 8.8%, which is below the regional average and the lowest level since 2009. Unemployment was as high as 17% back in 2013. Economic expansion for Q2’17 was recorded at 2.9%, the highest level in a decade. However, as with other developed economies, Portugal continues to struggle with lowly inflation.

It is no surprise that the benchmark curve has tightened considerably after the rating announcement, the yield on the 10-year rallied to levels not seen since the beginning of 2016. Also the benchmark 10-year is trading ~195bps wider than 10-year Bunds (at time of writing), the tightest level since the beginning of 2016. Portugal’s 5-year CDS has also tightened to ~135bps, to give some perspective, it was trading more than twice as wide at its peak in February. However, this is still pretty high, considering Turkey is only 25bps wider (at time of writing).

Despite the upgrade to investment grade, the country's hugely unsustainable debt level at 125% of GDP is one of the many concerns which prevents us from adding Portugal to our investable universe. Over the last couple of years the debt burden has floated around 130% of GDP and according to Moody’s is therefore one of the highest levels in the Ba1 space. The rating agency calculates that Portugal’s debt affordability, a measurement of interest payments to revenues, was as high as 10% last year; while Italy stands at 8.4% and Spain’s is 7.4%. Non-financial corporate debt is also higher than peers, at roughly 178% in Q1’17; thus a barrier to growth. The banking sector also remains a huge concern despite authorities’ steps to counter ~18.5% NPL ratios (Q1’17). That  aside, Portugal will not feature in our portfolios for some time as we still only assign the country 1 star on our NFA model and the curve does not offer sufficient risk-adjusted returns.

Across the border, Spain could face an independence referendum in just 13 days, after the Catalonia regional parliament approved the referendum vote. According to the bill, independence would be declared within 48 hours if the majority vote ‘yes’. And Catalonia would immediately ‘exit’ the EU and have to follow the same accession procedures as those member states who joined in 2004’, said EU Commission President Jean-Claude Juncker. Madrid is trying everything within its means to prevent the ballot from going through, with claims that it will not be accepted as a legal referendum. There have been reports that the Spanish government could go as far as cutting the electricity supply at the polling stations and possible brute force to ensure no-one can vote.

Catalonia’s economy contributes ~20% to Spain’s GDP currently. According to Spain’s economy minister, Luis de Guindos, Catalonia’s economic growth would shrink by 25-30% and unemployment double. As Catalonia would not be part of the EU, it could suffer export tariffs on as much as 75% of its products and services. Also, if the yes vote does go through, it will put Spain's Baa2/BBB+ ratings under pressure. We do not invest in Spain due to its low 2 star NFA ranking, and unattractive expected returns, however, we will continue to monitor the outcome over the next two weeks.