Euro Survival Hinges on Italy
0We are approaching the point where the ECB has to show its hand and accept its role as a lender of last resort. Yet, the question is how much further turmoil is required for it to do so?
Italy is the linchpin of the Euro-crisis: it accounts for 17% of European GDP, 7% of Germany exports directly and 25% of Euroland government bonds outstanding.
There’s talk of Italy leaving the euro, but were Italy (somehow) to leave the euro, the other members of peripheral Europe would be forced to leave as well, given the degree of competitive devaluation.
We have the following main conclusions:
■ Italian bond yields need to be below 6%-6.5% for the funding arithmetic to be sustainable. If the Italian parliament passes the austerity measures (as seems near certain) this week-end and then forms a
technocratic government enjoying widespread support with no elections until summer, this, together with some help from the ECB, should help Italian government (BTP) yields to fall to 6%. Yet, there is clearly much scope for political slippage.
■ If BTP yields stay at current levels, the ECB will have to increase materially its purchases of Italian government debt. Yet, it is unlikely to do so if Italy refuses to implement the agreed austerity measures. These are almost certain to pass, in our view. However, if they did not, we would really struggle to see how the euro survives in its current form. We would then expect a bleak outlook, with Euroland GDP falling by perhaps 5%, and the shock to confidence could drive the S&P500 index of US equities down to 800 points.
■ The moment the ECB starts to act as a genuine lender of last resort, we effectively get open-ended QE (even if the ECB is not printing money). In time, this would lead to QE3 in the US (owing to dollar strength) – and thus the end game: more printing and negative real 10-year bond yields, which would greatly alleviate government debt burdens, drive down savings ratios, reduce the cost of capital and push investors into risk assets.
■ The ECB may decide to postpone strong action until Italy’s 25 point plan is passed (which we may hope will happen this weekend). Yet, we believe that ultimately the ECB will be forced to move (not least
because of its vested interest, given that it owns/repos around c€600bn, as well as the fact that the ECB looks like it is being increasingly controlled by the periphery). Yet, the ECB would likely insist that the governments whose debt markets it supports are committed to meeting their fiscal targets. The only weapon it has to ensure compliance is its allowing bond yields to rise and thus the threat of a funding crisis.
■ There is widespread political support for austerity in Italy (albeit that different parties disagree on the specifics on pension reform, labour market reform and de-regulation). We can suspect that opposition parties will tone down their objections to specific proposals once it looks like they are going to achieve
power, just as was the case with Greece and Ireland.
■ There are only two long-term solutions to the situation in peripheral Europe: growth (via a weaker euro in the short term, higher productivity in the long term) or the mutualisation of debt (via Eurobonds or ECB buying – yet, in the short term, the ECB is the only practical option).
■ Italy in many ways is a liquidity problem that only threatens to be a solvency problem if:
a) cost of funding is too high (i.e., BTP yields stay above 6%-6.5%); or
b) there is no growth (because the ECB is not expanding its balance sheet, the euro remains too strong and productivity is structurally low).
Of course, this becomes a circular argument in both directions. We believe Italy’s fundamentals look better than those of Greece, Portugal or Spain.
■ On the negative side, the more policy makers in core Europe talk about the possibility of a country leaving the euro (following Sarkozy’s remarks on Greece last week and leaks on Reuters overnight), the greater the possibility of a default. This is because the deposit flight is likely to accelerate (there are still €187bn of deposits with Greek banks). Either this has to be offset by the ECB repoing more domestic bonds (thereby mutualising the debt) or loans in the periphery have to fall a lot further (leading to unsustainable deflation and default).
■ Continental Europe looks set to enter a recession, which is likely to get worse on the back of fiscal tightening of at least 1.2% of GDP next year, banks’ probably reducing risk weighted assets (RWA) by €1tn as well as the need for wages in Spain and Italy to fall by 5% to 10%. Clearly, the current government funding crisis in the periphery will only add to the negative economic momentum. Consequently, we believe the euro is likely to weaken, with the downward pressure reinforced by the ECB eventually having to expand its balance sheet.
■ Long-term investors prepared to accept significant volatility risks may buy equities given attractive valuations relative to bonds, reasonable economic momentum in the US and emerging markets, and the rise in global excess liquidity. That said there are unlikely to be many takers for Euroland financials and cyclicals!
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
