A House Divided, Euro-Style
You know Europe is up against it when the best news comes from Athens – compliments, as it happens, of its quirky neighbor on the Mediterranean.
In early June, the Greek government sold €1.65 billion worth of six-month paper with a yield of 0.85%, among the lowest rates for Greece sovereign debt in nearly a decade. At the same time, Rome went to the market to raise €5.5 billion of the same duration but at a higher yield—1.21% in fact, as investors demanded a bigger payout for assuming a perceived higher risk.
Meet Italy, Europe’s latest sick man. The election in Rome of a hybrid government – half socialist, half populist – has rattled markets at a time when the European Union’s economy has lost its vigor. The new leadership has inspired fears among executives that continental Europe’s third biggest economy will soon vote to leave the Eurozone. According to the latest CNBC Global CFO Council quarterly survey, more than 76% of executives are “somewhat concerned” about Italy leaving the bloc, while almost three out of four respondents said the United Kingdom economy has already been hurt by Brexit.
Will the virus spread? George Soros thinks so. Whatever you may think of the billionaire investor, he has an acute instinct for contagion and he has been an astute critic of the European project. Speaking in Paris a month ago, Soros pronounced that “Everything that could go wrong has gone wrong” against the backdrop of the refugee crisis and austerity policies as well as “territorial disintegration” as defined by Brexit. “It is no longer a figure of speech to say that Europe is in existential danger; it is the harsh reality.”
While that might be overstating things a bit – EU members are in better shape now than they were after the 2008 financial crisis, but we’ll get to that in a moment – we at Anfield have always been leery of a currency union that imposes a single monetary policy on economies as disparate as Germany and the southern periphery states such as Italy and Greece. Much as we would welcome a strong alternative to the dollar, the euro and its capital markets have failed to reach their full potential – a secular deficiency that weighs on the bloc’s cyclical performance.
Consider, for example, the euro’s recent slide in value against the dollar to its lowest level in a year. While the trend is positive for southern states who rely heavily on tourist revenues, an accommodating exchange rate policy would eventually compromise the EU’s stronger, more diversified northern economies with inflationary pressure during a period of slow growth. In a word: stagflation.
As it stands now, the EU appears to be losing momentum from the top down. This month it announced GDP growth slowed in the first quarter even as the European Central Bank agonized over the future of its bond-buying program. The economy slowed to 2.5% on an annualized basis, the weakest pace since the third quarter of 2016.
Looking forward, the ECB anticipates diminishing growth in 2018 GDP this year, from 2.4% to 2.1%, while 2019 and 2020 were kept unchanged at 1.9% and 1.7, respectively. Acknowledging that the “soft patch may last longer than forecast,” ECB head Mario Draghi also anticipated inflation would remain stable at 1.7% from now to 2020. But with the increase in near-term inflation due largely to high oil prices, as ZeroHedge pointed out, it would take another OPEC meeting or two to send inflation tumbling.
The specter of a US-EU trade war is also spooking forecasters; BoAML calculates that a 25% rise in tariffs on European cars bound for the US market could cut Eurozone GDP by at least 0.30%. It also estimates that, to offset a 0.70% decline in output attributed to tarification, the euro and dollar would have to trade at parity (meaning the euro would have to weaken relative to the dollar).
Meanwhile, Europe’s Markit PMI dropped to an 18-month low, of 54.10 from 55.10 in April. Industrial production in Germany, the continent’s growth engine, grew just 2.00% on a year-on-year basis in April, missing forecasts for 2.80% growth and down from 3.80% in March. The trend continued in France, where April industrial production contracted MoM and fell short of expectations for YoY growth. French manufacturing activity also missed expectations.
In the United Kingdom, the Confederation of British Industry warned that the country’s GDP could slow to 1.40% this year from 1.80% last year, while the leading employers’ organization, citing growing concern about the lack of progress in Brexit negotiations, suggested growth could fall further to 1.30% next year. As on the continent, manufacturing production in April fell in Britain.
It’s not all bad news, however. The EU’s southern states have since 2008 reduced their budget deficits and rationalized their debt-to-GDP ratios. And keep in mind that these economies are growing while in 2011 they were in retreat.
This begs the question: how useful are improved fundamentals in a rising interest-rate environment, assuming the ECB is prepared to follow the Fed’s embrace of Quantitative Tightening? Would sustained euro weakness, eroding demand for European debt and head-spinning political change finally slip the bonds of the world’s second-largest economy?
In his Paris address, Soros called for a profound overhaul of the EU, including an end to mandatory inclusion among its members in the euro bloc. No longer does such talk provoke outrage, not even in the heart and soul of European unity. Perhaps even EU elites understand that if they want things to stay the same everything will have to change.
I think an Italian wrote that.
 Giuseppe Tomasi di Lampedusa, The Leopard,1958