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The Problem With Portugal

5 October 2016 by Mark Holman

Whilst 2016 will certainly go down as one of the best years on record for government bond markets, that performance has not been universal across geographies. As we can see from the graph below, the generic 10 year yields have fallen aggressively everywhere, except for Portugal where they have actually increased.

Source: Bloomberg

This is not a peripheral versus core story either, as Spain, Italy and Ireland have all seen their yields move sharply lower. Portugal is very much an idiosyncratic story of its own, and one that we are increasingly worried about. Having been bullish on Portugal’s prospects from the depths of the peripheral crisis, a lot has happened to change our minds. The turnaround began with inconclusive elections in 2015, which resulted in a slowdown and reversal of some of the measures that the previous reformist, pro-austerity,  government had painfully put in place. With debt at 130% of GDP, this was far from ideal, but markets were far more forgiving in 2015 than they were in height of the sovereign crisis in 2011.

However, what happened in late December with Novo Banco will perhaps be remembered as the major catalyst in the Portuguese troubles. For those familiar with the story, the Central Bank decided to “bail in” five senior bonds in the Novo Banco capital stack, by taking them out of the solvent Novo Banco and allocating them instead to the insolvent “bad bank” that was created after the collapse of the nation’s biggest bank, Banco Espirito Santo. This highly controversial move broke with many bond market protocols and has effectively shut off the Portuguese banking system from capital markets in 2016.

The Central Bank, whose job it is to protect financial stability, in one fell swoop created global outcry and alienated some of the world’s largest investors.  At the same time, the Resolution Fund has been trying to sell Novo Banco, but now the For Sale sign comes with lawsuits hanging over it and the bonds in question marked in the 20s.

No economy can perform without a fully functioning banking system and this has been a major barrier to economic growth in Portugal in 2016. Both Moody’s and Fitch downgraded the Sovereign to junk in the immediate aftermath, joining S&P who were already at BB+, leaving the lesser known DBRS as the only agency to rate the Sovereign at the crucial investment grade level. Crucial because without the rating, Portugal would not qualify to be in the ECB’s QE programme as it stands today. The all-important DBRS rating comes up for review on October 21st. While we do not think a downgrade is all that likely, an outlook change is certainly merited and would serve to worry markets further. Having said that, we have already added Portugal to Greece as sovereigns that we currently see as uninvestable.

For investors that still wish to play in the periphery, our current favoured play continues to be Spain as the economy continues to perform without a decision making government, because cuts are not being made as no new budget is in place, and the reforms made by Rajoy’s former government continue to reap rewards. With a third election possible in December, it has not been the smoothest journey, but it feels that Rajoy is finally gaining the upper hand, in which case the march from periphery to core should continue.

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