Eurozone: A Bumpy Ride Ahead

by: Alfonso Ricciardelli

We long held the view that Germany would have never - regardless of which party was going to be in power in Berlin - agreed to substantial eurozone reforms.

To that extent, President Macron’s victory ended up being short-lived, and political instability followed immediately after, first in Germany, and then in Italy. Investors should expect further uncertainty going forward.

Italy and France both adopted an expansionary fiscal stance, and Macron's humiliating U-turn on a signature gasoline tax factually signals the end of his political project.

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The End of the Macron Illusion

Most political commentators and analysts correctly forecasted that the election of a pro-EU President in France would have "awakened Europe's animal spirit," delivering a positive shock to the eurozone economy, and finally driving inflation up to the ECB target of below, but close to 2%.

In fact, 2017 has been the best year for eurozone's growth numbers since the crisis, despite the political headwinds of a disappointing result for mainstream parties in the German elections later in the year. Even then, pundits thought that Merkel clinging on to power would have been enough to deliver at least some of the reforms the bloc so desperately needed.

Fast-forward to 2018, and as the eurozone economy slows down, there are signs of political strain within the common currency area that investors should not ignore.

There is currently no concrete agreement - despite some botched announcement - on the size of a - potential - eurozone budget, and the EU banking union has yet to be completed, as the European Deposit Insurance Scheme legislation sits idle on European Parliament "rapporteur" Esther de Lange's desk, amidst Berlin's opposition.

To retaliate against that, the Italian Chair of the ECON Committee in the European Parliament kept hostage for months the Non-Performing Loans legislative package that "northern" countries were pushing for. Eventually, only half of the package was agreed upon - banks will be forced to increase their provisions for troubled assets, but won't benefit from the originally planned "boost" to the NPLs secondary markets.

Neither has there been any further strengthening of the eurozone's safeguards. While there seems to be a de minimis agreement on transforming the ESM - arguably, the most effective tool in the hands of eurozone member states - in some kind of eurozone monetary fund, the fund is still not big enough to help large countries such as Italy in the event of a widespread crisis.

And, needless to say, decision-making within the Luxembourg-based entity requires quasi-unanimity, which makes it hostage - for good or bad - of the German Bundestag - not exactly great for prompt reactions to economic shocks.

Meanwhile, Macron's abysmal poll numbers now show that an overwhelming majority of French people have officially given up on him. To change the narrative, the Elysee, promptly reacting to Berlin's lack of interest for eurozone reforms, chose to give up on fiscal consolidation and reverted back to France's well-experimented expansionary fiscal stance, by approving a 2019 budget that includes a deficit to GDP ratio back up at 2.8%.

And if this wasn't enough, President Macron was, last week, forced to an embarrassing U-turn on an environmental tax (on gasoline) in order to placate violent protests from all over the country. The demonstrations were aimed at fighting what was seen as legislation skewed in favor of Macron's voting base, which lives in cities and doesn't usually drive.

The President thus had to make further spending promises that might deliver some temporary relief but that have been seen as dreadful in Berlin.

Meanwhile, most investors, even as they shrugged off the unexpected news that Angela Merkel would quit the leadership of the CDU party, rightly so as in any event, our understanding was that she was likely to remain chancellor, have shown some discomfort, given the uncertainty around a potential departure of the sitting chancellor in the near future.

Italy's Woes

As France turns rogue on fiscal spending, Italy continues to be a headache in Brussels, with the Commission and Rome now at loggerheads since mid-September over the 2019 budget.

Rome has by and large agreed to a reduction of its 2019 deficit-to-GDP headline number but still refuses to agree to what the Commission has privately indicated as the "magic" figure, which is 1.8%. EU officials have repeatedly signaled that only a "significant move" - not just a token concession - could have made a difference and insist that they are already being lenient in not pushing for their previously set target of 1.6%.

As things stand, Italy is still likely to be heading straight towards an Excessive Deficit Procedure, although there is a frantic effort to avoid it. In any case, at this point, markets have fundamentally priced-in the procedure itself, and a fine is seen - rightly so - as highly unlikely.

The irony of it is that the procedure will be inflicted on Rome because of past misbehaviors that this government has simply been adding on to. This goes to show that Italy's reluctance to follow EU budgetary rules is deeply rooted and is not a specific feature of the current "populist" coalition.

From Berlusconi's failure to pass austerity measures in 2011, which then led EU partners to effectively force a change in the country's leadership, to Renzi's pledge to keep the deficit at 2.9% for three years (a pledge he never had the time to make good on), from the countless requests for "flexibility" to the introduction of "safeguard" clauses that would be activated in the event the debt-reduction path had been abandoned, Italy has often been on a potential collision course with Brussels.

We do not anticipate anything dramatic to happen in the short term, and spreads are actually tightening if anything. But we would like to warn investors that there is no element in the medium term that points to a likely de-escalation in the relationship between Rome and Brussels.

The current government is popular and if it does succeed in establishing a "citizenship income" and in passing yet another tax amnesty, it will be almost impossible for future politicians to run against such measures.

On top of that, the Commission's EDP - likely to be launched at the end of the month - will almost certainly be used as an electoral weapon by both the League and the 5Stars in the upcoming EU elections.

On that note, it is currently unclear if a great performance from the League in May will lead to a break-up of the Italian government and a snap election - as polls might suggest League's leader Matteo Salvini could be tempted to force an early vote to get rid of his 5Stars ally.

For now, we understand he is busy divvying up the spoils together with his coalition partner, by appointing friends and acolytes at the helm of publicly-owned companies, agencies, and, most important, the public TV broadcaster RAI.

And while the situation should be assessed after the EU elections next spring, when Salvini will run against his former ally Berlusconi and even against the 5Stars, for the time being, we are told both the League and the 5Stars are focused on staying in power and are unlikely to rock the boat.

That doesn't mean that political risk will recede, and Italian yields will likely remain very sensitive to both negative and positive headlines alike for months to come.


All in all, there isn't, in the medium term, any indication that the EU or the eurozone will move forward with the changes they need to face future crises, and if this quarter's economic data is a signal of what's in store, investors should expect things to get worse.

The year 2017 looked more like a canary in the coal-mine, as investors were buoyed by the combination of political risk relief in France, ECB asset purchases, and a sustained global recovery. This year is instead about to end on a much direr note, with slow growth and a number on unresolved issues.

The EU, and the eurozone, more specifically, within it, while national leaders and Brussels officials kept themselves busy lecturing the United Kingdom on how to manage the Brexit process, lost the appetite to strengthen their structures, and Macron's inspiring speeches and "jupiterial" grandstanding turned out to be exactly that - pure theater.

While it's not inconceivable to predict the survival of the currency area - institutions, once they are created, tend to protect themselves against their own demise - the eurozone has so far proven incapable of overcoming its structural issues, and therefore, the expectation for the future is that a year like 2017 will be more like an exception.

Expect a bumpy ride ahead...

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.