The Italian ‘crisis’ has been front page news over the last month.
Without revisiting all the recent twists and turns, here’s the bottom line.
Siren voices are saying that Italy is in so much trouble that it’s bound to leave the EU at some stage.
As ever, though, it’s not that simple. We’ve seen major Euro-zone problems come and go before, such as the sovereign debt panic that followed the great global financial crisis. But thus far, the cracks have been papered over.
Meanwhile, though, another major global trend is developing. And this one won’t evaporate so handily. Nor will it be so easy to manage as a mere over-borrowing binge. In fact it could change all our lives…
In Europe, over the last month all eyes have been on the Italian ‘crisis’.
But how bad is it really?
Answer: maybe it’s not as big a deal as the gloomsters believe.
Sure, Italy’s economy has been – and still is – going nowhere. The national debt as a percentage of GDP has surged during the last decade (what’s more, suddenly everyone’s an expert on Italy’s TARGET2 liabilities, in other words what it owes the Eurozone’s internal payments system). And the country’s political position has been… well, typically Italian, i.e. it’s displayed varying shades of chaos.
And make no mistake about it. A forced Eurozone exit by Italy would make Brexit look like a picnic in the park. It’d be a massive nail in the single currency’s coffin.
Not being a huge Eurozone or indeed EU fan, I might even welcome that.
Sorry, veering into politics there. And I don’t expect an Italian departure from the euro anytime soon.
I reckon the EU elites will do anything within their power – either via persuasion or coercion – to ensure that Italy remains within the Eurozone club. And while Italian rhetoric will oscillate, depending on which politician is standing in front of the TV cameras at any one time, I don’t believe there’s any genuine desire to dump the euro.
For example, opinion polls show that most Italians – 59%, says Eurobarometer – support the country’s continued inclusion in the Eurozone. And last weekend, newly-appointed Finance Minister Giovanni Tria said the new coalition government had no intention of leaving the single currency and was planning to cut debt levels and pursue policies that wouldn’t undermine Italy’s financial stability.
While talk is cheap, neither equity nor bond markets are freaking out right now.
The Italian versus German 10-year bond spread has been widely cited as the key symptom of the developing crisis. It has symbolised the implied risk of lending money to Italy compared to Germany. After the spread increased around end-May to its widest since 2013, it has since narrowed on Tria’s comments.
Will there be more scares about Italy’s future?
Will these result in the country departing the Eurozone?
Never say ‘never’ – but I’m not convinced. Another fudged solution remains the most likely outcome.
But here’s the next big fear factor…
It’s typical of financial markets to miss the real story.
While they’ve been fretting about Italy, they’ve been ignoring something else that’s a lot more concerning.
Inflation is on the march.
At first glance, in the UK it’s getting no worse for now. May’s CPI inflation rate was unchanged at 2.4% despite fuel prices rising at their fastest pace since January 2011. But “price pressures further up the supply chain are building – input price inflation jumped up from 5.6% to 9.2% and factory gate price inflation rose from 2.5% to 2.9%, which could feed into the core rate of inflation in time”, notes Ruth Gregory at Capital Economics.
In the US, meanwhile, May’s headline CPI inflation has just hit a 2.8% six-year high.
Again that’s partly due to a 1.7% month-on-month increase in fuel prices. But May’s US core inflation, which omits the volatile bits, also increased 2.2% to a 15-month high. That’s up from April’s 2.1% year-on-year gain.
Worse, while crude prices may be losing momentum, another inflation-creating element is troubling financial authorities on both sides of the Atlantic.
Pay packets are finally growing.
In Britain, the headline three-month average weekly earnings excluding bonus measure (yes I know it’s a mouthful, but it’s the favoured benchmark with the Bank of England’s number crunchers) was up 2.8% year-on-year in April.
While that’s down a touch from March’s 2.9% print, it’s still ahead of the forecast by the Bank’s interest rate-setting Monetary Policy Committee (MPC) for the year as a whole of 2¾%. It’s also growing faster than CPI inflation.
And over in the States, the annual rise in US average hourly earnings increased last month to 2.7% from 2.6%.
To be fair to the Fed, unlike the equity market, it’s been aware of inflation risks.
That’s why it’s just raised its benchmark overnight lending rate by 0.25% to a range of between 1.75% and 2%. And it has dropped its pledge to keep rates low enough to stimulate the economy “for some time”. US policymakers also projected slightly faster future rate rises, with two extra hikes expected by end-2018 compared to one previously, followed by three increases next year.
This next part is even scarier.
David Rosenberg of Gluskin Sheff recently spotlighted a sharp rise in the voluntary ‘quit rate’ – i.e. the ‘take this job and shove it’ index – to its highest level for 18 years.
This matters because the quit rate tends to lead US wage inflation by around six months. It suggests that American pay packets are about to take off.
As Albert Edwards of Soc Gen notes, “if wage inflation leaps up in the US then it is likely that the Fed will keep tightening. They usually do until they break something. Since 1950, there have been 13 cycles in which the Fed tightened interest rates and 10 of these ended in recession. The other three tightening cycles saw emerging market blow-ups, like the 1994 Mexican peso crisis”.
Instead of worrying about Italy, I’d suggest watching inflation and wage rates.
We could be looking at the catalyst, not only for a global recession but also for a major financial market shake-out. Keep buying that gold…
But don’t just take my word for it.