The Outlook: June 2018 economic
commentary

Commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges.


Challenging times for the eurozone 

The region faces significant challenges during the months ahead, but a weaker euro could provide some relief 

Having been a source of an upside surprise in 2017, the news flow out of the eurozone has taken a notable turn for the worse in 2018. The recent turmoil in Italy has provided a reminder of the region’s structural vulnerabilities, the economy has slowed, and despite a downward revision to its growth forecast, the European Central Bank (ECB) has signalled its intention to wind down its quantitative easing (QE) programme by the end of the year. Against this backdrop, investors are understandably asking whether it is time to dump eurozone equities.

Take Italy first. The recent twists and turns of Italian politics, which resulted in the formation of a populist, eurosceptic League/Five Star Movement (M5S) coalition government on 31 May, have reawakened concerns of a possible break-up of the euro. As fears of “Italexit” grew during May, the yields on Italian bonds spiked, prompting wider market turmoil. However, with a snap election having been avoided and the government reaffirming its commitment to continued membership of the euro, markets have calmed down – 2-year Italian bond yields have fallen back to 0.6% from a peak of 2.43% on 29 May.

Budget compromise? 

Nevertheless, with public debt of 132% of GDP and the government’s policy proposals likely to significantly widen the budget deficit, worries about the country’s debt sustainability still carry the potential to unnerve markets. In 2017, Italy ran a primary budget surplus (ie. before interest payments) of 1.5% of GDP, but when interest payments are added in, the budget deficit rises to 2.3% of GDP. If the new government’s fiscal plans – including a universal basic income, a flat tax and repeal of recent pension reforms – are implemented in full, some estimates suggest the deficit could widen by over five percentage points.

Such a development would risk a credit rating downgrade and put Italy at odds with EU budget rules – a deficit is considered ‘excessive’ if it is higher than 3% of GDP. It is also likely to result in a renewed sell-off of Italian government bonds, that would raise debt servicing costs and potentially put the country’s debt on an unsustainable path. In turn, this would put renewed pressure on the Italian banking system, which has large holdings of government bonds.

A key question going forward is therefore whether the 2019 budget, which must be submitted to the European Commission by mid-October, will water down the government’s fiscal programme. There are good reasons to suspect that it will. Firstly, the market turmoil of May could provide a ‘wake-up call’ to the ruling parties and prompt a rethink. After all, a full-blown debt crisis would hurt ordinary Italians and is unlikely to be a vote winner. Somewhat encouragingly, the new finance minister Giovanni Tria has indicated that he will not allow debt to spiral out of control.

In addition, provisions to balance the budget added to the Italian constitution in 2014 should act as a constraint. Article 97 states that “General government entities, in accordance with EU law, shall ensure balanced budgets and the sustainability of public debt.” So even if the government did propose a profligate budget, President Sergio Mattarelli could veto it, much in the same way as he rejected the appointment of the eurosceptic Paolo Savona as finance minister.

A dovish taper

Renewed doubts about Italy’s finances come at a time when a big buyer of eurozone government bonds is signalling its departure from the market. As part of its QE programme, the ECB has accumulated over €340bn of Italian debt, around 15% of the total. However, at its June meeting, the ECB announced that from October it would halve its monthly QE bond purchases to €15bn and terminate the programme altogether by year-end.

Navigating the exit from QE was always going to be tricky given the potential to put upward pressure on bond yields and the currency. Given that QE has played a key role in lifting prices of risky assets, there was also the possibility that stock markets would react negatively to the news. However, in a deft move, ECB president Mario Draghi tempered the QE tapering announcement with dovish guidance, indicating that interest rates would not rise before summer 2019. With the US Fed now hinting at a faster pace of interest rate hikes, the ‘dovish taper’ from the ECB has helped keep the euro near 7-month lows against the US dollar.

This is good news for the currency bloc. Last year’s appreciation of the euro was a key factor behind the region’s recent economic slowdown – net exports subtracted 0.2% from quarterly GDP growth in Q1 – so a more competitive currency should, if sustained, support growth going forward. By providing a tailwind for exporters’ profits, it has also supported the equity market. Although heightened political risks have weighed on the Italian stock market in recent weeks, German equities have staged a comeback after falling during the first quarter.

Car wars?

This said, rising tensions over trade and a slowing Chinese economy are a source of concern given the importance of exports to the eurozone. The region will suffer indirectly from escalating tit-for-tat tariff exchanges between the US and China. However, President Trump’s threat to impose a 25% tariff on auto imports on national security grounds represents a bigger direct danger. Germany is most at risk – its car exports to the US were worth €22bn in 2016. The Ifo Institute for Economic Research estimates that the tariffs could reduce German GDP by 0.16% if implemented.

All of this argues for a cautious approach to eurozone equities during the coming months. Italian politics and US trade policy threaten significant downside, and the liquidity backdrop is becoming less favourable as the ECB dials back its monetary stimulus. But if Trump’s threats of new tariffs turn out to be just a negotiating ploy, and Italy’s forthcoming budget meets with EU approval, eurozone equity markets could reap the benefits of a more competitive exchange rate. It may be hasty for investors to completely turn their backs on the region.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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