The reasons for the regular bouts of political uncertainty that have invaded the consciousness of investors in eurozone assets in recent years were foretold by the economist Wynne Godley in a famous essay in the London Review of Books.
Mr Godley, who has legitimate claims to being the most neglected post-second world war British economist, worked as a Treasury civil servant and academic at the University of Cambridge. His 1992 article described how the single European currency would lead to economic stagnation in countries such as Italy, while Germany and other northern European nations would benefit.
Mr Godley’s rationale was that the economies of Italy, Spain and others on the periphery had currencies much weaker than the euro when they joined. He said the upshot would be that the imports of countries such as Italy would become less competitive with a stronger currency, while those of Germany would become more competitive because the euro, as a currency, is much more lowly valued than a sovereign German currency would be on its own.
This created a situation where German exports would be consistently competitive, but Italy’s less so. The economist outlined two scenarios to adjust for this: the first was the creation of fiscal union – that is, a EU-wide system of transfers of cash from rich to poor countries, with the entire wealth of the economic bloc treated as if the area was one country.
Mr Godley believed this option needed to be pursued in order for the single currency to function, but feared another option would be chosen instead.
The option that worried him was that countries such as Italy would try to make exports more competitive by driving down domestic inflation, and therefore wages, through labour market reforms.
Essentially, the idea was that if Italian workers received lower wages in real terms, that would make the cost of exports cheaper and compensate for the currency used in the country being stronger. This forms part of the economic theory popularly called austerity economics.
Shutting the stable door
Mr Godley feared that a lack of wage growth would provoke anti-EU sentiment in the countries on the eurozone’s periphery, and lead to political instability that would threaten the existence of the eurozone.
David Jane, who jointly runs about £911m of assets across four multi-asset funds at Miton, compares the situation with that between London and the north of England. He said: “London generates an enormous budget surplus every year, but we live in a democracy so we all vote and agree to transfer some of London’s wealth to the many parts of the country that are in deficit. But because Britain is one country, generally speaking people in or near London don’t mind doing this.”
Of course, each individual eurozone country is a democracy, but the voters in each country vote at a national level, so those they elect focus on the interests of their own taxpayers, rather than the collective interest of the economic bloc.
The effect of the existing policy can be seen in the fact that while Italy runs a current account surplus – it makes more from exports than it spends on imported goods – per capita GDP in Italy is lower today than it was prior to the financial crisis. That means GDP per head of population, a measure of the rate at which citizens have acquired wealth over the past decade, has fallen.
Growth in inflation-adjusted wages in Italy in the quarter of a century since 1992 is far lower than in Germany or the UK in the same period.
For some critics of the eurozone, the inevitable end result of the imbalances that course through the veins of the single currency is the collapse of the euro.
Mr Jane says the only alternative is for policymakers in the bloc to “accept the reality” that many peripheral eurozone economies will never repay the debts they owe.
Deficit-reduction policies
Countries such as Italy and Greece are able to borrow at far lower rates than is justified by the fundamentals of their respective economies because the European Central Bank (ECB) is buying the government bonds of those countries. But the bond buying comes as part of a package requiring those countries to implement measures to cut their budget deficit, creating precisely the economic conditions that are feeding the rise of populist politics.
The multi-asset manager notes the ECB is never actually repaid the capital amount for the Italian bonds it owns. When the time for repayment comes, the debt is simply “rolled over” with the issue of new bonds.
Mr Jane says: “It is simply the same as writing off the debt: the fact is there is only an accounting rule in the difference. What I expect to happen is the Europeans will kick the most kicked can in the world further down the road, but eventually they will have to stop worrying about the accounting rule and accept they are not going to be paid. There isn’t really any other option.”
This course of action is precisely what former Greek finance minister Yanis Varoufakis said would happen to his country when he was part of the team negotiating with the EU during the eurozone’s sovereign debt crisis in 2011.
Mr Jane says this plan will not affect the private sector owners of eurozone debt, as they will continue to receive payment, but not having to pay the publicly owned debt would mean countries such as Italy would have more capital to invest in measures that can boost economic growth.
His cynicism about the prospects for the eurozone have not prevented him from making a number of recent investments in Italian-listed shares.
The manager says companies such as Ferrari, in which he is invested, happen to be listed on the Italian stockmarket, but in practice have very little to do with the Italian economy. The value of those shares falls when sentiment turns against the eurozone, which he believes represents an opportunity.
The eurozone economy and stockmarket enjoyed a strong start to 2018, in line with the healthy performance of emerging markets. This is because many of the largest firms on eurozone stock exchanges are exporters, and particularly engaged in the sale of luxury goods.
Role of emerging markets
Sturdy emerging market performance is seen as a positive for the Italian economy, among others, because the goods it exports, including luxury cars, are in high demand from emerging markets in buoyant times. Crucially, luxury items such as Ferraris are bought without much consideration of price.
The result of this is the currency conundrum that plagues many eurozone economies does not impact on luxury goods sales. This is one way in which the fate of eurozone investments is somewhat reliant on the prospects of the emerging market consumer.
Bryn Jones, who runs £1.3bn across two bond funds at Rathbone Unit Trust Management, adds that political uncertainty in the eurozone counts as a “credit event”, whereby investors worry about a major issuer of bonds defaulting. The reaction to this fear is to sell off riskier assets and flock to safe havens.
Irrespective of fundamentals, emerging market assets are always viewed as risk assets, and so will sell off whenever there is a eurozone credit crisis.
If Mr Jane is correct that the structural problem with the eurozone will rumble on for years before policymakers stop kicking the can down the road, then there will continue to be sporadic periods of crisis, and investors’ reaction should be to flee emerging markets when volatility appears on the eurozone horizon.
David Thorpe is investment reporter at FTAdviser.com
