01 June 2018, 16:14 GMT
The latest turn of events has seen Spain’s Prime Minister Mariano Rajoy being ousted by Parliament in a no-confidence motion on Friday.
The opposition leader, the socialist Pedro Sanchez, has replaced him and is now the new Prime Minister.
Looking ahead, despite the changes at the helm, there is very little that the new Spanish government can actually do. The government that Mr. Sanchez now leads has a very slim majority in Parliament, and relies on the support from parties with very, very different political agendas. The room for manoeuvre on the fiscal side is also limited, with the 2018 budget already ratified by Rajoy before his departure. As it stands, in the short term it is difficult to see how long the new government will hold, and new elections appear likely in the months ahead.
Italy’s troubles throughout May triggered a spike in government bond yields. But despite political uncertainty in Spain, investors are likely to approach it differently from Italy alternatives for two reasons.
Firstly, in Spain there is much more support for Europe across the political spectrum and among the population, which should prevent a replay of the sparring and anti-Euro headlines that weighed on Italian assets in May. Secondly, Spain is in a stronger position, both on the economic and fiscal front. The country has implemented structural reforms, benefits from a structurally higher level of growth, and has a lower debt to GDP ratio than Italy.
These factors should lead Spanish Bonos to remain well supported and outperform BTPs in the near term.
However, investors should not consider Spain completely immune to volatility or external factors and must tread carefully when allocating capital. As we saw in the last week of May, Spanish assets can be heavily driven by the broader risk sentiment around peripheral debt. Should the Italian situation escalate again, and BTP yields rise, Spanish Bonos are likely to follow suit, with correlations between the two markets likely to remain elevated in the months ahead.
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