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Catalan Crisis: Broad Eurozone Contagion Still Unlikely

The Spanish economy has been on a strong cyclical uptrend until the recent political crisis. Economic sentiment could temporary weaken.

The already complicated political situation in Spain worsened again last week. Shortly after the Unilateral Declaration of Independence (UDI), the Spanish Senate approved the usage of Article 155, another unprecedented step since the establishment of the Spanish Constitution in 1978. This officially authorizes the national government to take control of the region and rule it directly from Madrid.

Political tensions and uncertainty are likely to persist over coming days in the region as control is slowly enforced by Madrid. The main risk is that confrontation escalates in the street or that Madrid uses a heavy-handed response to implement direct control of the region. However, the first business day since the trigger of Art. 155 has been calm and suggests recognition of the new election process by both sides. But it is still too early to fully gauge what impact the switch of power will have on sentiment over coming weeks.

Economic Disruptions (If Any) Should Stay Local

The Spanish economy has been on a strong cyclical uptrend until the recent political crisis. This was confirmed by the flash Q3 Gross Domestic Product (GDP) release, showing growth of 0.8% Quarter over Quarter and coming in line with expectations. According to the first indicators for October, Spanish economic confidence measured by the European Commission has remained robust to the political news flow. If uncertainty persists, economic sentiment could temporary weaken in Q4 2017 and Q1 2018 and start to impact the growth outlook, mostly in the Catalan region, which accounts for 19% of Spain's GDP. Indeed, corporates have reacted quickly to the uncertainties and nearly 1'500 companies have relocated their headquarters or legal base out of Catalonia. Tourism bookings in Barcelona have also started to decline due to the standoff. Overall, disruptions together with the heightened tensions could persist, but we think that it is unlikely to derail positive growth of the whole country beyond having a possible temporary impact.

Domestic Market Volatility Can Persist...

Marketwise, are Spanish assets at risk of a meltdown? As we highlighted previously, the escalation of the political crisis and question on its economic impact have led to volatility in the domestic financial market. Looking at equities, the Spanish index, financial names in particular, has been sensitive to the worsening of the crisis. But in absolute terms so far, losses have been fairly limited and the market has tended to rebound on positive headlines and Q3 earnings released so far have also been fine. In relative terms, however, Spanish equities have continued to underperform that of the rest of the Eurozone after 1 October. Keeping in mind the recent underperformance of the domestic market, a further correction remains possible but the attractive valuation relative to the rest of the Eurozone should help to mitigate any protracted downside in coming weeks. In the light of the prevailing political uncertainty, we keep our neutral relative stance on Spain and continue to favor Germany within our positive EMU equity strategy.

...But a Broad Eurozone Contagion Still Unlikely

Overall, we continue to see risks of a broad contagion to other European markets as being limited. Our base case is that the crisis will remain a domestic issue and the possibility of a re-emergence of a pan-European political risk premium due to Spain remains very low. Both parties in the Spanish crisis remain strongly pro-European. Moreover, Spanish banks that have relocated their legal base out of Catalonia will keep access to the ECB's emergency liquidity facility if they suffer from temporary deposit outflows, limiting contagion to other credit institutions. Across European asset classes, we believe that the cyclical economic recovery and still accommodative monetary and financial conditions will continue to play a more significant role in driving market sentiment beyond any domestic political concerns.