In a sequence of notes highlighting potential ‘17 flashpoints, we examineEurozone (China discussion here). In our view, Germany & Italy hold the key.
Huntington, in a controversial ‘90s classic (‘Clash of Civilizations’) asked, what isEurope? Whilst Istanbul, Tbilisi and Sofia are all geographically in Europe, wherewould one place its eastern frontier? The answer to Huntington was that the edgeof what is recognized as Europe runs along the ancient Holy Roman andHabsburg Empire frontiers. In other words, it separates Catholic and Protestantareas from the Orthodox and Muslim regions beyond. The argument was thatsocially and culturally some parts of Central Europe were artificially separated fromthe West and should easily integrate into EU (Czech, Poland, Hungary, Slovenia,Estonia) whilst areas outside ancient frontiers could encounter far greaterdifficulties (Serbia, Romania, Bulgaria, Greece) and still others are unlikely to evermake it (Turkey, Russia, Ukraine, Belarus). Europe is also unusual in having alarge island on its western edge (Britain), with a detached history. While his viewswere controversial, the last twenty-odd years have shown the resilience of culturalbarriers and broadly confirmed Huntington’s thesis.
Why is this important? In our view, it not only explains current conflicts in Ukraineor Crimea but also why EU is experiencing difficulties integrating states likeBulgaria or Romania. It also explains why Germany had been reluctant to bail outGreece, Italy or Spain. If given several more generations of peace and prosperity,it is possible that the western part of Europe could have evolved a more dominantEuropean (rather than German, Dutch or French) identity. Alas, it was not to be, asthe integration process ended following GFC. The project remained unfinished,and the cracks along the lines drawn by Huntington re-appeared. While theconcept of European identity is too powerful to die, it is also highly unlikely tosurvive in its current form; this applies even more so to the future of the Euro.
What does it mean for investors? ECB’s aggressive monetary policies,depreciating � and the ‘afterglow’ of China’s stimulus have been strengthening theEurozone’s recovery. It thus far survived Brexit and the Italian referendum andwhilst there are other elections on the horizon, its resilience has been impressiveand, in our view, is driven by investors’ perception that deflationary pressures haveabated. However, cyclical recovery masks deep fractures that continue toundermine �, and choices are getting harder. Monetary union must becomplemented by fiscal union and mutualisation of debt; or the Euro is ultimatelydoomed. Alas, it is highly unlikely that the forthcoming elections will support fiscalunion, debt mutualisation or sizable domestic stimulus by surplus states.
The intra-Eurozone imbalances are its Achilles’ heel. If Germany reduces itssurpluses and stimulates consumption, it would allow the periphery to recover.
However, no German stimulus = no rebalancing; Eurozone therefore has to try toexport its domestic adjustment, in a world where other states are doing thesame. Eurozone is also about to discover discomfort of inflation and that it mightbe worse than disinflation. Interest rates and exchange rates are becoming toolow for Germany but too high for Italy or Greece. In the absence of fundamentalchange, Italy remains the key global risk; far more than China (here). Since ‘99,its industries and banks were devastated, and it is unable to either improvecompetitiveness or devalue. Any contraction of liquidity without fiscal stimuluscould finally force Italy’s exit. Prisons look tranquil until inmates revolt. It all looksquiet now but any significant volatility spike could lead to an Italian riot and it is10x the size of Greece, with a total debt burden exceeding �6 trillion.
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