Many fund managers have begun to look at stocks and sectors on a pan-European basis as euro-common factors have supplanted country-specific influences on performance.
But not all of these euro-common factors have been positive. In recent years, slow growth, high unemployment and structural deficits have all caused concerns, leading to unease that the formula for integration, if not the policy itself, could be flawed.
At the root, much of the problem stems from the distinct dynamics in play in different countries. In Italy, structural problems in the domestic economy have left the country on the brink of crisis ahead of the impending election. At integration, Italy was helped by a Lira conversion rate that was, after past devaluations, below parity. This should have provided breathing space during which the political process could introduce economic reforms to remedy long-term weaknesses. Unfortunately, the reforms that have taken place have been sporadic and not always successful. Productivity growth over the past five years has been -1.5%, compared with +10% in Germany. Debt, against an EU target maximum of 60% of GDP, sits doggedly above 100%. Attempts to reform the labour market have only been partly successful. Devolution, intended to boost local control in a country of great regional variation, has too often resulted in local resistance to modernisation.
Much of the traditional Italian industrial base is under attack from cheap competition in Eastern Europe and Asia. In the past four years, the economy has hardly grown and there have been two recessions. A slight improvement in quarter two of this year only served to balance a poor first quarter, with the revival coinciding with a fall in the euro against the dollar.
At the macro policy level, Italy has agreed to end the use of one-off measures to meet longer-term economic objectives by next year. However, the strategic policy changes necessary to replace them are still awaited. This lack of action threatens censure and possible punitive action from the EU.
The situation is clearly unstable and could be brought to a head by the election which must be held before May 2006. As dissatisfaction is expressed more openly, the political temptation must be to shift the focus away from domestic issues towards the single currency and the policies of the ECB. Making the euro a villain is a dangerous tactic but an understandable one if the main opposition to the current government is led by Romano Prodi, the man who took Italy into the currency unionWhat does this mean for Europe? Along with joining France and Germany in pressuring for lower interest rates, Italy could demand specific concessions. Making an established EU member a ‘special case‘ would be a worrying precedent at a time when new countries are straining to meet the terms of membership but it could happen if Italy used the threat of a reduced status for the euro or even an exit from the single currency regime to back up its demands.
This threat would, however, be double-edged. For Italy, as well as a loss of credibility, there would be a huge increase in debt servicing costs. In 1995, the average yield on Italian government debt was 10.3%. In January 1999, with the single currency in sight, it had fallen to 7.4%. Currently, it is below 3%. Entry to the euro can thus be credited with saving Italy over $70 billion in annual debt servicing costs alone.
For investment markets, it would open a period of significant uncertainty. Holders of Italian debt currently enjoy a small premium income over the comparable German bond. But is this enough to compensate for the risk? Current yields assume a controlled monetary environment for the foreseeable future. Any threat to this must be reflected in a swift and sharp widening in spreads. Equity investors could be tempted by the attractions of a freer currency regime but the reality is likely to be volatility rather than sustained gains.
By John Kelly, Head of Client Investments at Abbe