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John Chatfeild-Roberts: EU faces significant political choices

Italy could end up being a bigger problem for the union than Greece

If investors didn’t experience enough of a frisson of danger from emerging markets, when the economies of Venezuela, Argentina and Turkey all suffered extreme strain, now Italy is setting everyone on edge in its own inimitable style. Italy’s coalition government, comprising those unlikely bed-fellows the left-wing anti-establishment Five Star party and right-wing on-off secessionist League, produced its first budget.

Having campaigned separately with their own radical agendas for taxation and social spending, they agreed a budget which exceeded most observers’ expectations of economic aggressiveness, in particular a planned budget deficit which defies all the European Union’s rules of fiscal probity.

There’s no subtlety in the challenge to Brussels: “We have a democratic mandate and this budget is consistent with our manifestos. Voters expect us to deliver on our promises. You have a problem with that?” It has overtones of the Greek crisis of 2014 to 2017 and the refusal to kowtow to Brussels’s (or, more accurately, Berlin’s) strictures when Greece was all but bust.

Italy’s budget challenge to Brussels
If Greece was a headache, Italy is potentially a bigger problem for the EU authorities trying to impose centralised economic discipline.

Italy is the eurozone’s third largest economy and the second largest manufacturer after Germany, but it is one of the most indebted nations on Earth. In short, Italy matters. Stockmarkets reacted swiftly to the budget, opting to shoot first and ask questions later. Italian government bond prices tumbled and investors pondered the possibility that the big bond rating agencies might declare Italy’s government bonds to be junk. Fears also resurfaced about the financial stability of Italy’s notoriously wobbly banking sector.

However deep-rooted Italy’s problems are, though, the essential safety valve normally provided by the currency is simply not there; there is no Italian lira to depreciate to relieve the pressure on Italy’s balance of payments.

In the Italian and Greek stories lies the inherent instability in the eurozone and the broader 28 EU countries (which will become 27 after Brexit) bound rigidly in a trading bloc, 19 of which are subject to a single currency, exchange rate and interest rate, regardless of individual economic situations but without the common fiscal policy in place to create a symmetrical, integrated, coherent system.

The bedrock of any sound fiscal policy is planned expenditure funded by income from taxation; it goes without saying that it is profoundly undemocratic to have taxation without representation, another facet of the union which would require substantial reform as a pre-requisite.

The EU comprises half a billion people spanning a wide diversity of cultures, social structures and political systems. It’s difficult to see all these significant economic, social and political tensions on the path to full economic and political integration being resolved soon.

Central banks change tone
Returning to our old friends the central banks, recent weeks have been noteworthy less for the quarter-point rise in the US interest rate band to 2 per cent to 2.25 per cent (the eighth such rise since this cycle began in December 2015), and more for the tone of statements from the US Federal Reserve and the European Central Bank.

The Fed declared its policy was no longer “accommodative”, pointing towards interest rates rising at least to the neutral rate, the point at which rates have neither an expansionary nor braking effect on the economy, and beyond which real policy tightening takes place. The neutral rate itself is not static, given the economy is dynamic, but at the current rate of US growth it would be around 3 per cent to 3.5 per cent.

The ECB, meanwhile, confirmed its intention to stop its QE money-printing programme at the end of the year, and interest rates are on hold at least into 2019. But common to both statements and with new emphasis was the reference to slowly but surely rising inflation, now spreading also to the labour markets in accelerating wages.

Relative to the double-digit inflation rates of the 1970s/1980s, the current rate hovering around 3 per cent seems child’s play. But for investors whose only experience is the decade since the financial crisis and inflation being largely absent, seemingly dead and buried, it should now be firmly on your radar.

John Chatfeild-Roberts is head of strategy for the Jupiter Independent Funds team

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