The Spanish equity market has entered an era of shareholder democracy as domestic investors begin to pile in seeking a higher risk-return profile than they can get from traditional fixed-income investments.
"We were forecasting an influx of Pta585 billion ($4 billion) in new investment in the equity market this year but what we've seen in the first five months has already exceeded our estimate," says Cecilia Planiol, chief economist at Santander Investment. "We are in a situation where for the first time in Spain people feel that low interest rates are here to stay. Hence they are looking for ways to enhance the returns on their investments, and this means switching out of fixed-income instruments into the stock market."
Most analysts agree that the economic environment could hardly be more favourable for the equity market. Short-term interest rates, now at 5.25%, are closing quickly on German levels and the market is convinced they will continue to drop sharply over the coming months. "In the next 12 to 18 months, Spanish short-term rates will have to come down by almost two points to reach convergence with Germany," says Ignacio Gomez Montejo, head of equity research at Merrill Lynch in Madrid. "There is widespread confidence that Spain will be among the first wave of countries into Emu [European monetary union] and with the downward trend in rates there is very little scope for any major market correction."
A record flow of redemptions
Inflation is running at about 1.7% and the Spanish consumer price index is expected to finish the year at slightly over 2%, helping to boost corporate earnings by a nominal rate of 15% compared with 11% in 1996. Macroeconomic figures continue to surprise even the most optimistic analysts, pointing to a further narrowing of the spread to Bunds and a 10-year yield falling to an historical low of 6.5%.
"We feel this is a good time to get into the Spanish market," says Jerker Johansson, managing director of Morgan Stanley's European Equity Capital Markets group. "Our view is that it still has upside and one reason for this is the underlying improvement in the economy. We are seeing large transactions for the first time. One or two years ago no-one would have thought of doing a $4.5 billion deal such as the Telefonica privatization. This is confirmation of stronger interest in the domestic market."
Given this situation, and the fact that Spanish equities have appreciated close to 70% since last year, domestic investors see little sense in holding their savings in traditional money-market instruments. It is hardly surprising that redemptions from fixed-income funds have been flowing into equities at record rates.
"A couple of years ago you could earn 12% on treasury bills and that was considered a highly attractive form of investment," says Mariano Colmenar, equity analyst at BZW in Madrid. "Taking fees into account, a money-market fund will today earn an average of 3.5%. Spanish investors are used to high returns so they are turning to the equity market and a higher risk-yield profile."
At the end of 1996 equities accounted for less than 4% of most Spanish investment fund portfolios. They are now nudging 5% and according to most estimates could easily reach nearly 8% by the year-end. There is ample room for growth - most European funds have average equity holdings of 25%. Jorge Calvet, managing director at SBC Warburg in Madrid, estimates that each 1% shift of funds from fixed income to equities amounts to $6.2 billion in added investment in the market.
"We have been witnessing a snowball effect in the market," says Victor Martinez, head of research at Argentaria Sociedad de Valores y Bolsa. "As soon as one fund manager starts increasing his exposure to equities the rest tend to follow suit. There is a vast pool of savings out there to provide the demand and market liquidity is certain to grow."
Lower interest rates, a bullish view on Emu and a boom in corporate profits are only part of the story. Prime minister Jose Maria Aznar's centre-right party, which came to power after last year's general election, has been greeted with enthusiasm by the market after prolonged political uncertainty under the faltering socialist government. Aznar has accelerated privatization and made strides towards relieving tensions in the labour market.
"A factor in the recent strong performance of the Spanish equity market has been the new law on labour-market reform," says Pedro Echeguren, an analyst at NatWest Markets in Madrid. "This is the first time that labour-market reform has been achieved through two-way negotiations without the government's intervention." The law approved on May 17 encourages permanent contracts and attempts to eliminate friction in wage negotiations. It also reduces compensation awards for unfair dismissals and helps companies to justify fair dismissal cases in court. "This will improve the social climate, dissipate fears and introduce changes beneficial to employers and workers," says Echeguren. "The frightening alternative would have been for Spain, with 22% unemployment, to lose competitiveness in a growing global market."
Aznar has also given direct encouragement to equity investment. A former tax collector, one of the first measures he brought in last year was a law setting a 20% capital gains tax ceiling on equity holdings. By comparison, money-market or current-account income computed as part of personal earnings can attract a rate of up to 56%.
Soaking up the paper
This June a massive Pta1 trillion will be released into the Spanish savings market with the redemption of the so-called special debt issued by the treasury five years ago at 2%. These bonds were issued as a type of fiscal amnesty for investors who had evaded income-tax payment. "In view of the favourable tax regime it would be logical to expect that money to go into equity investment funds," says BZW's Colmenar.
Domestic demand has been so strong in recent months that it has easily soaked up the paper left by foreign investors who, for the first time in a decade, have been net sellers of Spanish equities. "Foreign funds hold about Pta8 trillion in the Spanish stock market and so far this year they've been net sellers of up to Pta300 billion, or some 3% to 4% of their position," says Merrill Lynch's Gomez Montejo. "It's not a vast amount, but we believe this process will continue for the rest of the year. The Spanish stock market is about 5% to 10% more expensive than most European markets and it will remain more expensive."