By Emelia Sithole-Matarise and Alistair Smout
LONDON (Reuters) - Investors' love affair with Spain is cooling as they contemplate the possibility of slower reforms and a fragmented coalition government after elections later this year, with both bonds and stocks now underperforming their southern European peers.
Spain has been among investors' top picks this year due to a recovering economy under conservative Prime Minister Mariano Rajoy and the European Central Bank's drive to stimulate activity across the euro zone through bond purchases.
But the ruling People's Party (PP) suffered its worst result in 24 years in local and regional polls on May 24, raising investors' concerns that Rajoy could ease off on the reforms that have helped to turn the euro zone's fourth-biggest economy into the fastest growing in the bloc.
While the PP got more votes than any other party, its reforms remain unpopular with many Spaniards and new parties, including the anti-austerity Podemos, made gains.
The immediate market impact was hardly seismic, but there are signs investors are turning cautious, fearing the next government might need the support of radical parties such as Podemos after the elections expected in November.
Government bonds generally have suffered a rout in recent weeks but even before it began, Spanish borrowing costs had rebounded more sharply off record lows than those of either Italy or Portugal.
Italian and Spanish bonds had been among the main beneficiaries of the ECB's 1 trillion euro quantitative easing programme that spurred investors into the higher-yielding southern European debt as yields on top-rated bonds vanished.
Spanish yield premiums over benchmark German Bunds hit 2015 highs after the elections. Yields on 10-year Spanish sovereign bonds have risen 58 basis points so far this year to a seven-month high of 2.25 percent, nearly double the climb in Italian equivalents.
Spanish bond yields have largely been lower than Italian ones so far this year but the gap has shrunk close to parity.
"There is very much a nervousness within the investment community over the sovereign landscape within Spain. That is being driven by lack of visibility over the political outlook," said Chris Parkinson, head of research at Christopher Street Capital.
POST-ELECTION PERMUTATIONS
While Rajoy's PP seems likely to lose its parliamentary majority, nothing is certain. Among a long list of post-election permutations is a centre-right coalition of the PP and the new market-friendly Ciudadanos party, a coalition of Podemos and the Socialists or even a grand coalition. Some commentators believe the next government may be short-lived, especially if it is a minority administration.
In equities, Spain's blue chip IBEX index is up 9.3 percent year-to-date, lagging a 23.3 percent rise in Italy?s FTSE MIB and a 13.7 percent rise for the EuroSTOXX index of euro zone shares.
(For graphic on stock and bonds' comparative performance, please click on: http://link.reuters.com/tap84w)
Spanish firms' momentum is slipping. Analysts' estimates of their 2015 earnings have been downgraded by 0.2 percent over the last 30 days, compared with a 1.5 percent upgrade for Italian companies, Thomson Reuters Starmine data shows.
Capital expenditure is at risk. "Any kind of political uncertainty tends to make companies reticent to invest," said Parkinson. "If they don't know what the political climate is going to look like... they're not going to embark on any major capex programmes, and that has a knock-on effect on the broader company, and could drag the economy into a quagmirish state."
Spain's economy grew 0.9 percent quarter-on-quarter in the first three months of this year, outpacing 0.3 percent growth in Italy and Germany and 0.1 percent in France.
SPAIN VS ITALY
A recent fund manager survey by Bank of America/Merrill Lynch showed Spain was the second most favoured equity market in Europe in May, after Germany. This means they are "overweight" Spain, investing a larger part of their portfolio in the country's market than its size relative to others.
However, fund managers wanted to be less overweight Spain last month than they had been in April. By contrast, more fund managers wanted to be overweight Italy for the next year when asked in May than in April, closing the gap with Spain. When investors are largely overweight an asset, it could fall swiftly if sentiment suddenly switches.
A trigger would be any sign of growing support for Podemos. "You could probably price in an extra 25 to 50 basis points in risk premia as a result on Spanish sovereign bonds," said Sanjay Joshi, head of fixed income and London and Capital.
Podemos is often compared with Syriza, the radical leftist party that leads the Greek government, but has toned down its policies in recent weeks, scrapping some ideas such as defaulting on the national debt.
Falling returns on government bonds have also led some Spanish banks to cut their holdings of the country's debt. They were the most aggressive sellers of the bonds in April, offloading about 11 billion euros' ($12.5 billion) worth, according to latest central bank data. Italian banks, which were net sellers the previous month, increased buying of Italian sovereign debt by 10 billion euros.
"With regards to positioning, we're in a wait-and-see mode at the moment, to see the impact on markets," said Christoph Riniker, head of equity strategy research at Julius Baer.
"But if we have to choose between Italy and Spain within peripheral markets, we would tend to Italy at the moment, because there is less political risk."
(Additional reporting by Julien Toyer in Madrid; Graphic by Vincent Flasseur; Editing by Nigel Stephenson and David Stamp)
