A populist Eurosceptic government, paired with a budget deficit target below 2% and membership of a monetary union is putting a lot of pressure on the Italian economy. The inflated currency strength due to strong countries like Germany sharing the Euro and the inability to use independent monetary policy has cornered Italy into a tough spot as its growth weakens.

Italy saw two consecutive quarters of negative GDP growth at the end of 2018, entering into a technical recession in the process. This was widely anticipated by financial markets with a lot of the damage already priced into assets early in the year when Italian bond yields soared vs German Bund yields and equities sold off in both October and December. Yields spiked because markets were fearful of Italy’s new proposed spending plans which included increased welfare spending, tax cuts and an introduction of universal income with an already huge debt load; at the time debt was at 131.2% of GDP making it the second largest in Europe just behind Greece. These measures put Italy’s budget deficit on track to breach 2.4% in 2019, a sharp fall from the previous target of 0.8%. This lead to conflict with the European Commission who monitor and check Eurozone budgets. They made a statement indicating the draft plans were an “unprecedented” deviation from EU spending rules. After Rome was told to revise its budget, plans were made that put the budget deficit target at 2.04%, an improvement but significantly less than European officials had hoped for originally.

Why is Italy’s budget of such a great importance to the European Commission? Why are Italian leaders revolting against the EU’s decision? What does this mean for the Euro?

The answer to these questions can be found in the following economic principle: An effective instance of a common currency regime requires free flow of capital and labour, similar languages and pension scheme provisions and similar business cycle fluctuations within member states. Further to this, if the member states differ widely in their wealth and economic strength then a fiscal transfer system should be in place to transfer wealth from the strongest members to the weakest members.

The United States is a great example of a common currency regime with Miami, New York and Texas all sharing the Dollar. This Dollar regime has also been effective due to the fiscal transfer system in place and the use of a common budget. The collection of countries using the Euro is perhaps less so, as evident by the differing strength of the German and Italian economies. Germany runs a strong trade surplus and benefits from an artificially weaker currency, the Euro, than if it were standalone using its own currency. Germany produces and exports high ticket sale items such as vehicles and machinery including computers and is the largest national economy in Europe. Italy runs a positive, but lower Balance of Trade and is unable to compete with the manufacturing skill, efficiency and expertise of German firms who operate with more flexible working hours and contracts and are in centre of Europe reducing shipping costs relative to southern European countries. With economies differing in fundamental strategy their business cycles are not completely synchronised (Nor are they completely aligned with Spain, France or Greece…) When recessions hit, or economic booms give rise to inflation the modern strategy would be to implement monetary policy by an interest rate cut or hike respectively, smoothing the natural fluctuations of the business cycle.

However, the International Economics Theorem: “The Impossible Trinity” renders this impossible.

The Impossible Trinity:

The Impossible Trinity states that it is impossible to have all three of the following: Free capital flow, a fixed exchange rate and sovereign monetary policy. One must select only two and give up the other. Italy, by virtue of being in the Euro monetary union, has given up its right to independent monetary policy and is tied to the rate set by the ECB.

This is where things get tricky for Italy. The ECB has kept rates at historical lows and implemented great easing through its asset purchase programme pushing yields down. However, recent ECB comments have suggested that we are likely to see interest rate hikes towards the end of summer 2019, and the Quantitative Tightening will reverse the asset inflation we saw in this bull market, putting Italy in a hard place. Lower liquidity and an increased cost of borrowing will be hard to stomach for a country already in a recession. Italian leaders see how challenging this situation is and many are adopting an ever more Eurosceptic stance. It appears that a Eurozone crisis 2.0, similar to the one that hit Greece, is arguably moving away from just a possibility given recent conditions. With tensions high in Europe, a no deal Brexit on the table and continued French protests, the structure that holds Europe together, whether that be the EU or the Euro, is under attack.

As investment managers we must take a view on the economic and political developments in order to make effective asset allocation decisions. We have adopted a neutral equity stance, but an overweight in Large Cap US stocks compared to Large Cap European stocks. Earnings have been supportive, valuations are attractive and a sooner end to the Fed’s Balance sheet reduction programme could see multiple expansion on equities. However, we appreciate political conditions and Trade Wars are risks to portfolios and hence we have continued to hold our overweight gold position as a tactical defensive play.