Jupiter Merlin Weekly: EU/eurozone - An economic Frankenstein’s monster?
Jupiter Merlin Weekly: EU/eurozone - An economic Frankenstein’s monster?
This Merlin Weekly Macro analyses the strains on the Italian economy in the broader context of the eurozone’s financial system, described as a ‘monstrous monetary lash-up’.
In July last year with the appointed Italian caretaker “technocrat” government having just collapsed under the leadership of former ECB President Mario Draghi, we described in these columns how investors had responded by ‘blowing out’ the spread between the yield on the Italian 10-Year Government Bond (known as ‘BTPs’) and the safer German equivalent, the 10-Year Bund. As the perceived idiosyncratic risk rose and investors dumped Italian BTPs in favour of German Bunds, the yield differential approached 2.5 percentage points. 250 basis points, as 2.5 percentage points is known in the market lingo, has the hallmark of a binary barrier: when the spread exceeds it, almost like a demarcation line, anything over the wire is staring into the abyss.
An Italian Gordian Knot
Today, with that sense of déjà vu, although only at 200bp spread (4.85% for Italian 10-Year yield against 2.85% for Germany), there is that feeling of “here we go again”. The risk is that it becomes a self-fulfilling prophesy: as government borrowing costs rise faster in Italy than elsewhere in the eurozone, so the financial strain on Italy becomes greater; as that strain grows and if nothing significant is done by the Italian government to mitigate against it with corrective policies, up goes the perceived risk and with it, the bond yield. As the bond yield rises, so does the cost of capital. And so we go round the Mulberry bush in ever decreasing circles.
This time, the direct fault lies with Georgia Meloni and the year-old coalition government led by her right-wing Brothers of Italy party. She walked into a trap of her own making: under-delivery on an over-promise based on an unfeasibly short timescale. She promised she would get a grip on Italy’s finances; rashly, with very little time to deliver, she said that in 2022 she could cut the government deficit to 5.6% of GDP: it came out at 8%; for 2023, the budget was for a 4.5% deficit which earlier this month had to be revised to 5.3%; and next year’s target of 3.7% has risen to 4.3%. While clearly much better than the position inherited from the damage wreaked by Draghi’s predecessors, the unlikely coalition of the right-wing League and the loony-left, self-styled anarchist jokers that were Five Star, nevertheless investors see the positive momentum slipping away.
The short-term problem is daunting: a financially over-geared economy (debt/GDP is 144.7%) is sliding. While technically not in recession, which is defined as two consecutive quarters of shrinkage, nevertheless GDP declined by 0.4% year-on-year in the second quarter. But the risk is posed by the confluence of an unholy trinity of challenging conditions: financing costs which since the beginning of 2022 have risen from below 1% to 4.9% on the 10-year bond today; GDP going nowhere; and critically, the markets knowing from ECB schedules that in 2024 Italy needs to refinance government debt worth the equivalent of virtually a quarter (24%) of its entire GDP.
Note that we have not used the adjective ‘systemic’ to describe the noun ‘risk’. As we wrote last year, Italy will not go bust; not in the conventional sense. International ratings agencies are keeping a close eye on Italy’s economic data and have their red pens poised to downgrade the creditworthiness of its debt, bearing in mind that currently the average rating is only a couple of notches above ‘junk’ (i.e. high risk, invest with eyes wide open). Looked at another way, if Italy were an accession country wishing to join the EU, currently it would fail the test by a wide margin (to be fair, so would another seven of the 19 members of the eurozone, including Spain and France). It would have to demonstrate a history of both debt/GDP not exceeding 60% and a deficit not exceeding 3% of GDP. In fact, although persistently in deficit since last century, it has had unbroken periods of being within the 3% ceiling (e.g. 2012-2019); the problem is that with no growth and that enduring deficit, not once since 1991 has its government debt been less than 100% of GDP. On such shaky economic foundations significantly exacerbated by the ECB’s 6-year policy of negative deposit rates sucking the life out of it, Italy’s creaking banking system has had to be propped up regularly by a series of creative financial confections courtesy of that very same European Central Bank, all designed to stop it falling over.
As the third biggest economy in the EU and much more importantly the eurozone, and its second largest manufacturer, were Italy’s financial disintegration in prospect, it would not be allowed to happen: if Italy were to fall over, so potentially would the euro, one of the world’s reserve currencies. Nobody wants that. As with Greece a decade ago, the ECB, Brussels and the broader international financial machinery would pull out all the stops to prevent a collapse. To be clear, we are nowhere close to that. However, if not red, the warning lights are at least flashing amber. Incidentally, but to prove what can be done, in the intervening decade since Greece was on the brink of causing a eurozone melt-down, robust corrective action has almost restored Greece’s credit rating to Investment Grade, a big boost to its international respectability and helping limit the cost of servicing its remaining debt (compared with 4.9% on Italian BTPs, Greece’s 10-Year bond carries a 4.2% yield).
This time, the direct fault lies with Georgia Meloni and the year-old coalition government led by her right-wing Brothers of Italy party. She walked into a trap of her own making: under-delivery on an over-promise based on an unfeasibly short timescale. She promised she would get a grip on Italy’s finances; rashly, with very little time to deliver, she said that in 2022 she could cut the government deficit to 5.6% of GDP: it came out at 8%; for 2023, the budget was for a 4.5% deficit which earlier this month had to be revised to 5.3%; and next year’s target of 3.7% has risen to 4.3%. While clearly much better than the position inherited from the damage wreaked by Draghi’s predecessors, the unlikely coalition of the right-wing League and the loony-left, self-styled anarchist jokers that were Five Star, nevertheless investors see the positive momentum slipping away.
The short-term problem is daunting: a financially over-geared economy (debt/GDP is 144.7%) is sliding. While technically not in recession, which is defined as two consecutive quarters of shrinkage, nevertheless GDP declined by 0.4% year-on-year in the second quarter. But the risk is posed by the confluence of an unholy trinity of challenging conditions: financing costs which since the beginning of 2022 have risen from below 1% to 4.9% on the 10-year bond today; GDP going nowhere; and critically, the markets knowing from ECB schedules that in 2024 Italy needs to refinance government debt worth the equivalent of virtually a quarter (24%) of its entire GDP.
Note that we have not used the adjective ‘systemic’ to describe the noun ‘risk’. As we wrote last year, Italy will not go bust; not in the conventional sense. International ratings agencies are keeping a close eye on Italy’s economic data and have their red pens poised to downgrade the creditworthiness of its debt, bearing in mind that currently the average rating is only a couple of notches above ‘junk’ (i.e. high risk, invest with eyes wide open). Looked at another way, if Italy were an accession country wishing to join the EU, currently it would fail the test by a wide margin (to be fair, so would another seven of the 19 members of the eurozone, including Spain and France). It would have to demonstrate a history of both debt/GDP not exceeding 60% and a deficit not exceeding 3% of GDP. In fact, although persistently in deficit since last century, it has had unbroken periods of being within the 3% ceiling (e.g. 2012-2019); the problem is that with no growth and that enduring deficit, not once since 1991 has its government debt been less than 100% of GDP. On such shaky economic foundations significantly exacerbated by the ECB’s 6-year policy of negative deposit rates sucking the life out of it, Italy’s creaking banking system has had to be propped up regularly by a series of creative financial confections courtesy of that very same European Central Bank, all designed to stop it falling over.
As the third biggest economy in the EU and much more importantly the eurozone, and its second largest manufacturer, were Italy’s financial disintegration in prospect, it would not be allowed to happen: if Italy were to fall over, so potentially would the euro, one of the world’s reserve currencies. Nobody wants that. As with Greece a decade ago, the ECB, Brussels and the broader international financial machinery would pull out all the stops to prevent a collapse. To be clear, we are nowhere close to that. However, if not red, the warning lights are at least flashing amber. Incidentally, but to prove what can be done, in the intervening decade since Greece was on the brink of causing a eurozone melt-down, robust corrective action has almost restored Greece’s credit rating to Investment Grade, a big boost to its international respectability and helping limit the cost of servicing its remaining debt (compared with 4.9% on Italian BTPs, Greece’s 10-Year bond carries a 4.2% yield).
All roads lead to Rome?
Italy’s problem is structural and enduring and historically intractable. Locked into the euro at an exchange rate which was too strong (a big drag for its exports) but significantly advantageously weak for Germany, its principal exporting competitor, Italy’s economy has stagnated. Almost literally gone nowhere in two decades. Between 2006 and 2022 it grew by 3.1%; not 3.1% per year but 3.1% in total. Over the same period, France grew by 19.9% and Germany by 36.0%. Looked at another way, since 2006 GDP per capita in Italy has declined by 2.5% while in France it has increased by 8.6% and in Germany 16.2% (in context over the same period, the UK economy grew by 20.6% and GDP/capita by 8.2%). Italy has had 69 governments since 1945, each lasting an average of a year and a month; it has had 11 since 2000 (still, look on the bright side: the average since the Millennium has improved to one every two years!).
The EU and the eurozone: an economic Frankenstein
Italy has its own national difficulties, that much is clear. However, it is part of a bigger more problematic system, one that is asymmetric and half-baked: it is not only an EU member, much more importantly it is in the eurozone. Italy is enveloped in a straight jacket which gives it precious little wiggle room. It is an old story you have heard us recount many times before. That we are doing so again is because absolutely nothing has changed to resolve the situation. The application of a blanket single currency and monetary policy without any debt union to 19 disparate countries with different economic and social fabrics and no common fiscal policy, is as fundamentally dumb as it is economically illiterate. It was not designed this way. A united Europe is entirely a political project. The idea was that monetary union was the icebreaker, the irreversible precursor to what was seen as the inevitable seamless glide to full economic and political integration. That it never happened is a political failure.
Now, locked in limbo, unable to go backwards and politically incapable of going forwards, there is a gaping fault-line running through the system. Countries such as Italy, those confronted by high debt and persistent deficits, are most at risk from some level of seismic shock. In Italy’s case, locked into an uncompetitive exchange rate inappropriate for its own social and economic structure, it has lost control over the two natural safety valves available to countries with normal, national, integrated economic systems: its own currency and its own fully functional national central bank, which would allow it to regulate and relieve the cumulative economic pressure.
The Italian problem, and the Greek one before it, illustrates the extent to which what the ECB presides over is less a slick, sophisticated financial policy apparatus than it is a monster monetary lash-up. Its principal peers in the US, the UK and Japan can focus on national economic policy (and heaven knows getting that right is difficult enough). The ECB on the other hand spends significant energy fighting fires trying to maintain a reasonable level of equilibrium in an over-complicated system which is inherently unstable and which, left to its own devices, would not only fragment but literally disintegrate.
Why does that 250bp spread between the Italian BTP and the German Bund become important as a trigger? Because the European Financial Stabilisation Mechanism (EFSM) which channels emergency funds raised through the markets to needy beneficiaries, guaranteed by ‘Brussels’, relies on EU collateral. That collateral in turn is provided by the eurozone members’ government bonds whose value is determined by their own creditworthiness. The lower the ratings agencies’ assessment is of a member state’s bonds, the less the ECB is prepared to accept those bonds because their collateral value is poor. The problem is magnified when the mechanical process of quantitative easing (QE, when the central bank buys bonds in a period of ‘loose’ policy) is reversed by quantitative tightening (QT) as we have now.
Now, locked in limbo, unable to go backwards and politically incapable of going forwards, there is a gaping fault-line running through the system. Countries such as Italy, those confronted by high debt and persistent deficits, are most at risk from some level of seismic shock. In Italy’s case, locked into an uncompetitive exchange rate inappropriate for its own social and economic structure, it has lost control over the two natural safety valves available to countries with normal, national, integrated economic systems: its own currency and its own fully functional national central bank, which would allow it to regulate and relieve the cumulative economic pressure.
The Italian problem, and the Greek one before it, illustrates the extent to which what the ECB presides over is less a slick, sophisticated financial policy apparatus than it is a monster monetary lash-up. Its principal peers in the US, the UK and Japan can focus on national economic policy (and heaven knows getting that right is difficult enough). The ECB on the other hand spends significant energy fighting fires trying to maintain a reasonable level of equilibrium in an over-complicated system which is inherently unstable and which, left to its own devices, would not only fragment but literally disintegrate.
Why does that 250bp spread between the Italian BTP and the German Bund become important as a trigger? Because the European Financial Stabilisation Mechanism (EFSM) which channels emergency funds raised through the markets to needy beneficiaries, guaranteed by ‘Brussels’, relies on EU collateral. That collateral in turn is provided by the eurozone members’ government bonds whose value is determined by their own creditworthiness. The lower the ratings agencies’ assessment is of a member state’s bonds, the less the ECB is prepared to accept those bonds because their collateral value is poor. The problem is magnified when the mechanical process of quantitative easing (QE, when the central bank buys bonds in a period of ‘loose’ policy) is reversed by quantitative tightening (QT) as we have now.
Putting sticking plasters on top of patches
In July 2022, when the ECB began raising interest rates and announced the reversal of QE, markets quickly zeroed in on where the weak links in the chain were, notably the fiscally weak, debt-laden eurozone economies including Italy. As bond spreads rapidly widened, the ECB was forced to respond. In an unscheduled meeting giving the impression of panic, the ECB introduced an emergency “anti-fragmentation” programme (officially called “Transmission Protection Instruments”), allowing full quantitative tightening for the economically stronger eurozone member states, while continuing with bond purchasing (QE) from the weaker ones (all the time, counterintuitively raising their interest rates).
It is obvious that when the ECB starts taking a differential approach among eurozone members, the notion of full monetary union is a chimera. The integrity of the system is being tested again today. Other than the application of yet more sticking plasters, however sophisticated, strategically the position will not be resolved without debt union. And there will be no debt union without fiscal union (sometimes known as the principle of mutualised debt obligations, the issue is one of asymmetric risk between accountability and responsibility: crudely why would Germany unconditionally underwrite the debt of Italy when it has no control over the workings of the Italian economy?). And joining the dots, as we have done so very often in these musings on this subject, the prerequisite for fiscal union is political union because in any functional democratic system the fundamental condition for taxation is representation. The clue is in that word ‘democratic’: from the ancient Greek, ‘demos’, the people; ‘kratos’, power. And the likelihood of political union in the foreseeable future is nil.
It is obvious that when the ECB starts taking a differential approach among eurozone members, the notion of full monetary union is a chimera. The integrity of the system is being tested again today. Other than the application of yet more sticking plasters, however sophisticated, strategically the position will not be resolved without debt union. And there will be no debt union without fiscal union (sometimes known as the principle of mutualised debt obligations, the issue is one of asymmetric risk between accountability and responsibility: crudely why would Germany unconditionally underwrite the debt of Italy when it has no control over the workings of the Italian economy?). And joining the dots, as we have done so very often in these musings on this subject, the prerequisite for fiscal union is political union because in any functional democratic system the fundamental condition for taxation is representation. The clue is in that word ‘democratic’: from the ancient Greek, ‘demos’, the people; ‘kratos’, power. And the likelihood of political union in the foreseeable future is nil.
The unofficial EU motto: “Homogenise, Pasteurise and Sanitise”
From an investment standpoint, the relevance is not just about bond volatility today. For so long the EU has been obsessively interested in its own navel: preoccupied with managing a political project and trying to achieve uniformity across its jurisdiction by regulation. At the same time it has made no progress towards the logical conclusion of its political goal of full integration. The insidious but corrosive result is that it has lost 10 percentage points of global share of GDP in 30 years, down to 15%, now overtaken by China (18%) and with the US stable at 25%. In the Jupiter Merlin multi-manager portfolios, while we indirectly have exposure to good quality European companies through the global equity managers with whom we invest, we remain disinclined at this juncture to invest in ‘badged’ European equity funds. We never say never again, but the immediate prospect remains unappealing.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
Authors
Investment Manager & ESG Investment Director, Independent Funds/Merlin
Investment Manager, Jupiter Independent Funds/Merlin
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