Portugal: PSPP dominating electoral uncertainties and macro vulnerabilities

Uncertainty about the Portuguese political situation has persisted after the inconclusive 4 October election. Below I discuss how: (i) a minority centre-right (PaF-led) government remains the most likely outcome but the chances of a left-wing coalition seem to have risen and the uncertainty could persist for several weeks; (ii) several cyclical/structural vulnerabilities mean that Portugal’s recent broadly satisfactory economic performance is unlikely to improve sharply, with risks seems skewed to the downside especially in the medium term; (iii) ECB PSPP, with Bank of Portugal purchases skewed to long-maturity PGBs, seems to be trumping the political uncertainties and nascent macro concerns. Likely further ECB dovishness (Draghi’s ECB press conference next week will be interesting) may well offset any intensification of the Portuguese political standoff in the next couple of weeks, although the extent can be imperfect.

Politics: Minority centre-right government central case but uncertainties have grown

The 4 October election produced an inconclusive result: the incumbent Centre-right PaF coalition (alliance of PSD and CDS) led by Passos Coelho won but fell short of a majority in attaining only 39% of vote (104 out of the 230 parliamentary seats) down from 51% in the previous election. A minority PaF-led government remains the most likely eventual outcome. But there are growing uncertainties – with the Socialists (32% of vote) theoretically capable of forming a coalition with previously anti-austerity left-wing parties (Left Bloc and the Communists, 18% of vote) and apparently leaning increasingly in that direction – which could take several weeks to resolve. In the interim the Portuguese government will remain grateful for PSPP.

Specifically, socialist party leader Costa’s attitude switched from pre-election hostility to the PaF (promising to oppose the proposed 2016 budget proposals) to being more conciliatory immediately after the election (stating that he wouldn’t pursue a “negative majority” with the left-wing parties and would rather negotiate with the PaF coalition). But recently he seems to have swung back the other way: on 13 October he declared that the Socialists were closer to an agreement with the left-wing parties and are “in a better position than the right to form a government that will be stable for the next four years” than the PaF. He also mentioned that the left-wingers had dropped their previous opposition to EU fiscal rules (perhaps inspired by Syriza!) which if true could be important, since the Socialists have previously seemed ideologically closer to PaF. But the suspicion would still be that a leftist government would be less fiscally responsible, more suspicious of euro membership and less inclined to undertake structural reforms – all of which could start worrying markets, although they have the comfort blanket of PSPP (see below).

The charts below illustrate that the Portuguese fiscal position has improved notable in the past few years, with the primary balance moving into surplus, but remains a nascent vulnerability. But Portugal also has one of the highest government debt-to-GDP ratios within the Eurozone (129% of GDP in 2015 Q2, versus 136% for Italy), with that ratio rising by one of the most amongst the eueozone members (the 32.5pp, rise exceeed’s Greece’s 22pp rise but is less than Spain’s 38pp rise).  Such a high debt burden constitutues an ongoing vulnerability.  Moreover, Portugal only has an above-junk credit rating, necessary for eligibility in ECB QE, from a single credit rating agency (DBRS).  Hence any new administration will have to treat very carefully.

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Importantly, however, recent polls suggest that a left-wing coalition is supported by around only a third of voters. And the Socialists may well be wary of suffering a larger eventual electoral hit if they form a short-lived coalition (i.e. which results in fresh elections in a few months). Indeed, President Cavaco might resist giving the mandate to a leftist government if he feels that it doesn’t guarantee the political stability he has called for in recent weeks (despite Costa’s claims). That said, Socialist party leader Costa faces probably being sacked if he doesn’t get into government and so will have personal reasons for pushing for a left-wing coalition. Following PaF leader Coelho saying last week that he wouldn’t be holding any further talks with Costa President Cavaco stepped in by announcing that he would be meeting both leaders next week.

Given the complex dynamics at play I suspect that it could take several weeks before the situation is resolved. And even if the PaF-led minority government (the most market friendly outcome) does eventuate the Portuguese history of minority governments not going to full term suggests that another election could be held in the next couple of years (although electoral law prevents this happening before six months after the end-2015 presidential election).

Economy: OK recent performance but lots of ground to make up and vulnerabilities

Overall the Portuguese economy has performed fairly adequately since exiting the bailout last year. But several vulnerabilities mean that a growth acceleration seems unlikely and indeed a slowdown possible.

Portugal has transitioned from having one of the worst recessions (annual GDP growth bottoming out at -4.5% at end-2012) to being in the pack more recently (+1.6% Q2 2015). Growth has been supported by a relatively-strong private consumption (+3.2% yoy Q2 2015) and strong export growth (+7.4% yoy Q2 2015) even if even stronger imports (+11.9% yoy Q2 2015) means that overall the external sector has continued subtracting from growth. While gross fixed capital investment has reported relatively strong growth rates (+5.1% yoy Q2 2015) and has supported GDP a little the big picture is that it remains substantially below pre-crisis levels: like Italy and Spain there is a substantial crisis-induced capex shortfall to make up. And there are several vulnerabilities potentially challenging the continuation of the recent performance (at the least a growth acceleration seems unlikely).

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First, continued weak consumer confidence and labour market issues are potential negatives for future consumption. While the recent consumption strength can’t be disputed (and indeed is towards the top end of EA performance) its notable that like investment its very much a story of partial catch-up to previous weakness. And notably while Portuguese consumer confidence has picked up in the past couple of years it remains weaker than most other EA members, especially for the “major purchases” category (latest read of -59.5 versus -3.3 for EA and +22.7 for Germany). The labour market also remains a structural weakness. While the 12.4% unemployment rate is substantially below Spain’s 22.2% it is above the EA aggregate (11.0%) and the IMF has highlighted the continued inflexibility of Portuguese labour market, the disproportionate share of lower-skilled jobs and considerable labour market slack for such workers. Moreover, Portuguese retail sales growth has slowed quite sharply in recent months.

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Second, a loss-making banking sector with rising non-performing loans is a negative for credit supply. Portuguese banks have continued making losses in aggregate in the past couple of years, making it an outlier within the Eurozone in this respect. Alongside this, non-performing loans are on the rise. Both factors will tend to inhibit credit supply and hence the support from ECB policy easing.

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Third, falling industrial confidence and a debt-laded corporate sector which unlike other EA members has not deleveraged are negatives for credit demand and investment. It’s notable that the European Commission survey shows Portuguese industrial confidence easing back a little in recent months, on the back of weaker (export) orders, contrary to general rises reported for other EA members (unfortunately there isn’t a Portuguese PMI). And Portuguese industrial production growth has also slowed recently, although less than retail sales and it remains within the pack.

But a longer-burn adverse factor is that Portuguese corporates remain highly burdened by debt (non-financial corporate debt of around 150% of GDP) as there has been substantially less deleveraging than e.g. in Spain. Such indebtedness will reduce credit demand (I discuss the EA-wide impact of high debt burdens here and my concerns about lending flows here), again tending to reduce the impact of ECB PSPP.  And of course, it adds to the vulnerability generated by the large government debt burden discussed above (i.e. there’s a bit of “double sin” here)

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Fourth investment has been weak in the tradeable sector, a negative for longer-term export prospects (competitiveness). I previously detailed how there was a substantial overall investment shortfall for the Portuguese economy to recoup, with adverse impacts on longer-term growth potential. It’s also telling that FDI into Portugal has been almost entirely destined for the non-tradeable sector, with very little ending up in the tradeable sector. In combination with the lower-skilled nature of the Portuguese labour force (see above) this increases the suspicion of Portuguese exports continuing to be focussed on lower value added sectors, which are likely to be more subject to intense international competition.

So the recent relatively-strong Portuguese export performance, which has likely been helped by the euro’s depreciation around ECB PSPP, may well be difficult to expand upon and indeed could be vulnerable to a longer-term slowdown. Moreover, the apparent import-appetite of the Portuguese economy to a relatively modest pickup in domestic demand (imports +11.9% yoy Q2 2015 versus +3.5% yoy domestic demand) raises questions about the strength of import-competing industries. That said, the Portuguese current account has been in small surplus since mid-2013 (+0.6% of GDP Q2 2015).

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Bond market: PSPP dominant (and likely more to come)

Despite the continued political uncertainties plus the combination of cyclical and structural vulnerabilities discussed above bond markets have remained apparently sanguine about the Portuguese situation. Specifically, 10y PGB yields have only risen by around 14bp since the election, with the 10y PGB-Bund spread up 10bp over same period, although 10y BTP yields actually fell a couple of bp. Moreover, 10y PGB yields remain 70bp below their mid-year levels.

That limited reaction in part reflects a market consensus that a PaF minority is the most likely outcome, with perceptions (hopes!) that no sharp change in policy woukd be likely to occur should a Socialist-led coalition instead eventuate. A radical policy change seems like a lowish-probability risk scenario given the impression of general consensus of the need to reduce the deficit (which has already fallen significantly but remains a further relative vulnerability of the Portuguese economy). The reported fiscal rules volte face by the Left Bloc and the Communists reinforces that impression, although I haven’t yet seen them confirm Costa’s statement to that effect. But investors will nevertheless likely be a little less relaxed should a Socialist-led coalition emerge from the party negotiations (still a lower probability than a PaF-led minority, but seemingly on the rise).

But the ECB’s PSPP seems likely to have been at least as important in calming Portuguese bond market nerves. Indeed, it’s notable that the Bank of Portugal’s PSPP purchases have been the longest maturity within EA, at around 11 years (versus 8 years for the entire programme and 7 years for Bundesbank purchases). Moreover, next week’s ECB meeting could at the margin add to that balm by raising expectations of PSPP expansion/extension – likely offsetting nascent upward pressure on PGB yields should the Portuguese political situation deteriorate.

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The lack of new staff forecasts means that ECB fireworks shouldn’t be expected next week.  But it will be interesting whether Draghi echoes Couere’s 12 October dovish message that “it is certainly our duty to be prepared to cope with all kinds of contingencies” and/or Nowotny’s 15 October surprisingly dovish statement that “One has to say that we’re clearly missing our target…it is quite obvious that in the current economic situation additional sets of instruments are necessary“. It will also be interesting to hear Draghi’s views on the potential adverse macro impacts of the the VW crisis (see here, next week’s PMI data should give us a taste of the scale of the effects).

With the ECB concerned about nascent EUR strength (see here) and EURUSD remaining stubbornly close to 1.14, given increasingly dovish Fed market views, Draghi will likely not want to disappoint dovish market expectations e.g. by offering further hints of further eventual action.

My expectation remains that the ECB will likely announced a 6-12 month PSPP expansion at their December meeting, when the inflation and growth forecasts seem likely to be lowered to more plausible levels (see here). Indeed, this could conceivably come alongside potential improvements to the ECB forecasting model to address it’s relatively poor forecasting record which ECB Vice President Constancio’s Jackson Hole paper hinted at.

But given the now near-universal consensus that the ECB will act in December, if Draghi et al want to stem the nascent euro appreciation (which they are partly responsible for by making it a funding currency see here) it seems increasingly likely to have to again suprise on the dovish side (the Fed delaying liftoff into 2015 has ambiguous impacts on EUR). And it seems like the bar for such dovish suprises is rising: market expectations of further ECB (deposit) rate cuts have been growing.  That’s something that Draghi has explicitly previously ruled out, so there may be credibility concerns about any potential U-turn (even if other central banks have gone further into negative rate territory without any apparent large adverse impacts).

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