Eurozone troubles – déjà vu all over again?

The new Eurosceptic, populist government in Italy has come to power at a time when the eurozone economy is slowing. EU markets and the euro now look vulnerable, but the UK market and the pound are still mired in Brexit uncertainty.

Italy: the melodrama continues

One thing I love about Puccini’s Tosca is that everybody knows that in Act III the heroine will hurl herself off the parapet to escape the villainy of her tormentors. And yet the diva’s dramatic swoop still comes as a climactic shock when it happens. Italian politics is not so very different. You know it will all end in melodrama – and yet one observes with grim fascination.

The Italian election took place back on 04 March – when the right-wing League, together with its partners in the centre-right coalition emerged as the largest bloc with 37 percent of the national vote and 265 seats in the Chamber of Deputies. The populist Five Star Movement emerged as the largest single party with 32 percent of the vote and 227 seats out of 630.

81 year-old former Prime Minister Silvio Berlusconi refused to play the role of power-broker, saying that his conservative Forza Italia party would not seek to join the government. If the Lega are sometimes characterised as neo-fascists, the 5-Stelle are often branded anarchists. What could possibly unite them?

What the leaders of the insurgent 5 Star Movement and the conservative League agree on is that the EU is causing Italy harm. Firstly, it has failed to stop mass migration to Italy from across the Mediterranean. The immigrants are overwhelmingly Africans who alight with the help of people traffickers from Libya. Secondly, they deeply resent the Maastricht criteria by which eurozone member states must reduce their fiscal deficits to three percent of GDP or less and to bring their national debts down to 60 percent of GDP. Thirdly, they oppose reform of Italy’s indulgent pensions system – and other spending cuts.


Of course, the Maastricht criteria have never been rigorously enforced: Italy’s debt-to-GDP level is currently around 132 percent. But the country has been compelled to make cuts all the same, lest that metric soar out of control. And Italians do not like it. It is as if a glutton, in full appetite, has been told he must go on a diet.

After weeks of political deadlock, President Sergio Mattarella last week gave the law professor, Giuseppe Conte, the task of forming a new cabinet. He was to have led a populist coalition to be formed between the Five Star Movement and the League, which had reached substantial agreement on a government programme.

However, on 27 May 2018, Signor Conte renounced the office due to differences between the League’s leader, Matteo Salvini, and the President. Signor Salvini had wanted the university professor Paolo Savona as Minister of Economy and Finances – but Mattarella adamantly opposed him, considering Signor Savona too Eurosceptic and “anti-German”. In his address after Signor Conte’s withdrawal, President Mattarella declared that the two parties wanted to bring Italy out of the eurozone, and as the guarantor of the Italian Constitution and country’s stability he could not permit this.

Some radicals from both the Five Star Movement and the League called for the president’s impeachment, saying that he did not have the constitutional right to reject the coalition deal. But President Mattarella just ignored this; and on 28 May 2018 he appointed the independent economist Signor Carlo Cottarelli as Prime Minister of Italy – but just to lead a caretaker government until such time as Italy holds new elections, probably in the late autumn. Signor Cottarelli, an alumnus of the LSE, who has worked at the International Monetary Fund and with the Banca d’Italia, is a mainstream Europhile economist of whom Mr George would approve.

It’s NO to Berlin, NO to Paris and NO to Brussels

So the populist ball was to have been kicked into touch – much to the temporary relief of Paris and Berlin. But the markets took a dim view of these machinations. On 29 May European bourses opened down and continued to haemorrhage value all day. In the event, late on 31 May, President Mattarella re-appointed Signor Conte as PM – and he is due to be sworn in on Friday, 01 June. Matteo Salvini will be Minister of the Interior; Luigi di Maio, the Five Star leader, will be Minister of Labour; and the Finance Minister will be another academic economist, Giovanni Tria.

{I do hope my readers are still following as I have had to rewrite the above paragraph eight times…And Signor Tria has just made it to Wikipedia in the wee hours of Friday morning!}.

The fear was that another round of elections would have reinforced the outcome of the March election. Support for the patriotic, conservative League has surged in recent opinion polls – the promise of a flat tax of 15 percent is particularly alluring. The Five Star Movement, which is predominantly popular in the poorer South – il Mezzogiorno – promises a citizen’s income of €780 a month for the unwaged.

Italy has made progress of late, at least in the eyes of the ECB. It is running a current account surplus of 2.8 percent of GDP by creating internal deflation within the eurozone whereby prices and wages fall relative to those of eurozone neighbours. But that’s the problem. Ordinary Italians are feeling the pinch. And unemployment is woefully high. However, in contrast to Greece, about 72 percent of Italian debt is owned by Italian entities – so Rome might need Europe less than Europe needs Rome in the years to come.

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After another election it would have been more difficult for the President, who has lost political capital, to defy the wishes of the two largest parties in parliament. Italians will not tolerate more EU-driven austerity; nor do they want another technocrat Mario Monti-style government imposed by the Paris-Berlin axis. During the election campaign Signor Salvini said:

We couldn’t give a damn about bond spreads. It’s NO to Berlin, NO to Paris and NO to Brussels. Italians are going to decide for Italy from now on.

It has been surprisingly little reported that the Lega-Five Star agreement comes close to suggesting that Italy could launch its own parallel digital currency which would function in parallel with the euro as a first step to Italy recovering its own currency. This was the brainchild of Claudio Borghi, the League’s economic spokesman. Italy’s disentanglement from the euro could really come to pass, precipitating a political earthquake across the eurozone.

It is not yet Act III. But the markets now suspect that there will come a point when the diva will plummet from the battlements with a piercing scream.

Spain: Señor presidente del Gobierno Rajoy esta saliendo

The threat of a general election in Spain was averted last week – just. The governing Partido Popular is heavily implicated in a network of financial scandals. One thread of this is that senior politicians (and their networks) have been accused of taking bungs in return for the award of government contracts. Allegations of corruption – which come under the general heading of the Gürtel Affair – go to the very highest levels of national government.

The Spanish parliament, the Cortes, will debate a motion of confidence on Senor Rajoy’s government on Friday, 01 June bought by the Socialist opposition – so I do not know the outcome as I write but it is likely that the government will be defeated. What we do know for sure is that Senor Rajoy’s authority has been punctured at a moment when the economy is softening.

Furthermore, the question of Catalonia’s independence lingers, with a curious but pregnant calm having descended on that country/province. Its new regional president, Quim Torra, is even more staunchly pro-independence than his predecessor, the deposed Carles Puigdemont, who is currently on bail in Germany after having fled to Belgium in October to avoid arrest…

All told, Spanish politics is in a pretty pickle. This would not matter much if the overall polity of Europe were not under such extreme stress.

Eastern Europe: Opéra bouffe

Miloš Zeman was re-elected as President of the Czech Republic in late January, narrowly defeating his pro-European liberal rival, Jiří Drahoš. Although the powers of the Czech president are limited, Mr Zeman has made a name for himself by being a vocal Eurosceptic with strong pro-Russian views.

Then Hungary’s Prime Minister, Viktor Orbàn, was convincingly re-elected on 08 April with nearly 50 percent of the vote. Both Mr Zeman and Mr Orbán have been vociferous opponents of Muslim immigration to Europe as a whole and into their own countries in particular. The Polish government too has been a vigorous opponent of further European integration and to Brussels foisting refugee quotas onto member states.

So the “Višegràd Group” of Eastern European states is increasingly plotting a course which is quite opposite to that proposed by President Macron, with his visions of much greater integration. The main focus of mainstream analysis is on the North-South cleavage within the eurozone. But an even more significant cleavage is surely that between East and West. The French elite have not yet grasped this. They will soon.

European banks: under pressure

The shares of European banks – often seen by analysts as a proxy for political risk – were down last week. In addition to perceived political uncertainty in Italy and Spain a number of other risk factors have become apparent. First and foremost, European growth stalled in Q1 2018. As a result, bank credit growth has been lower than expected. And expectations that the euro yield curve would steepen have been disappointed, thus weakening the prospects for improved bank margins. Moreover, on 25 May European finance ministers agreed on tighter bank capital standards. This will most likely force most banks to impose more restrictive lending criteria.

Further, the escalating financial crisis in Turkey poses a threat to Europe’s banks. Turkey collectively has foreign country obligations of $450 billion. About $150 billion of that is owed by Turkish banks to foreign creditors – overwhelmingly European banks. The Turkish current account deficit last year was in the order of $50 billion.

Turkish GDP grew robustly in 2017 but largely powered by supercharged credit growth. Turkey’s current account deficit widened. With falling confidence this year, the Turkish lira has fallen by almost 20 percent. That makes it more difficult for Turkey to repay the $180 billion falling due over the next 12 months.


Turkey’s official international exchange reserves – at around $135 billion – are inadequate to the task. In any case, they are inflated, according to some sources. About half of the central bank’s reserves (not including gold) consist of FX deposits by commercial banks with the Central Bank of Turkey. Therefore, if Turkish holders of foreign currency deposits should decide to move money abroad (especially in view of the mooted imposition of capital controls) the official reserves could rapidly diminish.

According to the Bank for International Settlements (BIS), Spanish lenders are most at risk from their Turkish exposures with $83 billion. Next come France with $34 billion, Italy with $18 billion and then Germany with $12 billion. Spanish lender BBVA (BME:BBVA) seems to be particularly exposed, having derived about one fifth its profits from Turkey last year through its 50 percent stake in Türkiye Garanti Bankasi (IST:GARAN). Italy’s Unicredit (BIT: UCG) is also vulnerable given that it owns 41 percent of Yapi ve Kredi Bankasi (IST:YKBNK), Turkey’s fifth largest bank.

If Unicredit of Italy gets into trouble at the end of this year it would presumably get no support from the ECB. But what if it were to go to the Banca d’Italia seeking a bail-in of Italian retail bondholders…? Would Signor Silvino or Signor di Maio breach EU rules restricting state aid to the banking sector? Things could get interesting.

Brexit uncertainty: Continent cut off by fog in Channel

The 15 months since Mrs May triggered Article 50 has not been Britain’s finest hour. In fact it is beginning to feel that Brexit has more in common with Dunkirk than with the Battle of Britain.

The problem is not just that the negotiations have been protracted and directionless, but that they are sucking the energy out of a government that should be focussed on fundamental structural problems. That could indeed be Monsieur Barnier’s intention: to engage the British in a psychological war of attrition in which the prospect of a settlement remains forever elusive. (The Europeans have already done something similar with the Swiss.)

The direction of the British economy under Messrs Cameron and Osborne (whom I affectionately called the Cameron-Osborne pantomime horse, so coordinated were they, despite their flaws) was much more assured than under Mrs May and Mr Hammond. Some business leaders are calling their leadership dysfunctional, citing the bungled government apprenticeship scheme as one example of how much vaunted initiatives amount to little. Then there is the dithering over immigration policy, housing policy and delays to key infrastructure projects, the third runway at Heathrow Airport being a case in point. The Prime Minister has already backed this project – but MPs are due to have their say in the summer. (Labour will no doubt oppose it just to torment Mrs May.)

Britain’s digital infrastructure is also in need of an upgrade. Britain does not compare favourably for 4G mobile connectivity which bodes ill for 5G – which will be essential to facilitate autonomous (self-driving) vehicles. Only 3 percent of Britain’s households and businesses benefit from fibre optic connections.

On 15 May the deputy governor of the Bank of England, Ben Broadbent, described the UK economy as “menopausal”. Even so, the Bank believes the UK growth figure for Q1 2018 of an anaemic 0.1 percent is likely to be revised upwards towards 0.3 percent. Mr Broadbent and others fear that the UK will find it hard in future years to achieve its long-term trend growth rate of about 2.4 percent.

Worryingly, foreign investment in Britain plummeted by 90 percent to $15 billion last year according to the OECD. But for all that, there are still reasons to contend that the doomsayers of Project Fear were wrong.

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The British economy has not gone over a cliff. Domestic business investment is bearing up – last year it rose by 2.4 percent – not good enough, I grant you, being the lowest level in the G7. Wages (at 3 percent) are rising faster than inflation (at 2.5 percent) – so they are not going backwards.

And there is no Brexodus of EU workers out of the UK. In fact, the number of EU citizens working in the UK has soared by 155,000 to 2.37 million, according to the ONS. It seems that the number of workers from the poorer countries of Eastern Europe has marginally declined but this has been more than offset by a rise in the number of workers from the wealthier countries such as France and Germany, who are less likely to have recourse to the welfare system.

The UK stock market has been one of the worst performing major equity markets over the last two years, despite the recent rally, mainly due to the pronounced uncertainty over Brexit and fears of a Corbyn takeover, as I wrote last week. Domestically exposed stocks in the UK have substantially underperformed those with mainly international sales. UBS reckons that the valuations of certain prominent UK domestic-oriented stocks are at record lows based on several metrics. It cites Travis Perkins (LON:TPK), Barratt Developments (LON:BDEV), Capital & Counties Properties (LON:CAPC), Derwent (LON:DLN) and Lloyds Bank (LON:LLOY).

Some directors of companies listed on the London market are so frustrated by the low valuations prevailing that they are thinking of selling out to the private equity barons. One such is Mark Dixon who founded IWG (LON:IWG) (previously Regus) in 1989 and is now the world’s largest operator of serviced offices. IWG’s competitor, WeWork, backed by the Japanese fund SoftBank (TYO: 9984) is valued at around $20 billion despite having made a pre-tax loss of nearly $1 billion last year. IWG, which generated net income of nearly £150 million last year, is valued at just £2.8 billion.

Another reason to re-focus to UK domestic stocks is that sterling looks oversold against the US dollar on its relative strength index (RSI). UBS reckons that on this basis sterling is tracking two standards deviations below its average. That implies a rebound soon.

A slowdown in Europe

Eurozone output rose by 0.4 percent in Q1 2018 further to a more robust 0.7 percent in Q4 2017. The slowdown was particularly sharp in the currency bloc’s two main economies, France and Germany. German growth slowed from 0.6 percent to 0.3 percent while French growth fell from 0.7 percent to 0.3 percent. The evidence now is that the eurozone will not be able to sustain the solid growth performance of 2017.

Eurozone economic sentiment has failed to revive in May, damping down hopes for a quick recovery after disappointing growth Q1 figures[i]. Economic confidence in the eurozone fell for the fifth consecutive month in May, dipping to its lowest level since August 2017. The European Commission’s economic sentiment indicator remained roughly unchanged in the eurozone, dipping 0.2 points from April to 112.5. That was better than analysts had feared, however.

While unemployment in the UK has fallen to a 43 year low of 4.2 percent, the average for the eurozone remains much higher at 8.2 percent. In France, unemployment is 8.8 percent; in Italy it is 11 percent and in Spain it is 16.1 percent.

The reckoning

The European Summit that will seal the deal on Brexit takes place in Brussels in less than four weeks’ time, on 28-29 June. If that were to result in a breakthrough, with Mrs May attracting a standing ovation, that could swing sentiment dramatically in favour of the London market and sterling could undergo a remarkable reversal of fortune.

Sadly, however, as I shall explain next week, that is not going to happen.

[i]See: https://www.ft.com/content/75401e66-63eb-11e8-90c2-9563a0613e56?emailId=5b0e74e71878b800040dfdc9&segmentId=488e9a50-190e-700c-cc1c-6a339da99cab