Be Bullish on Europe?

Back in April I wrote about the challenges that the Eurozone and the European Union at large were facing. Economic catastrophe and another big debt crisis stood knocking on the door as Covid-19 was ravaging Southern European economies and threatening the solvency of countries like Italy and Spain. But this position has shifted a full 180 degrees as the situation has evolved rapidly, undoing many dissuasions to investment in Europe in the past two decades in a matter of weeks. Such are the times we live in now! That’s not to say, however, that everything is all wine and roses. Europe will still face a turbulent road ahead with a long, painful restructuring and recovery, but there is now light on the other side of the tunnel.

European markets have long lagged behind their British and American peers. Many reasons have eroded confidence in European businesses, the prime of which was the debt crisis that unfolded in the 2010s following the financial crisis. I explained previously that the infamous PIGS group, including Portugal, Italy, Greece and Spain, never fully recovered from the 2008 crash, and that forced their governments to implement harsh austerity agendas to avoid defaulting on the sovereign debt. On the other hand, robust recovery in Germany and the UK and sizeable fiscal stimulus in the US meant that the gap between these countries and the PIGS became larger and more apparent.

The rationale this time around is that, since all Eurozone countries are so deeply interconnected, strong performance for all would also benefit all.

Following the economic fallout from Covid-19 we talked about how the populist governments in Italy and Spain wanted Eurozone countries to issue a single Eurobond that would package investment-grade German debt with that of struggling countries to lower the cost of borrowing and allow for more fiscal stimulus. Historically, such moves have been shunned by Germany and other wealthy nations, like the Netherlands and Denmark, who would have to pick up the tab for Southern Europe’s out-of-control spending. But this time things have turned around. The European Commission (EC) expects to be given a green signal to raise €750 billion debt under a common issuance backed by the entire European Union (EU).

The European Union will essentially enable the commission to raise debt by issuing AAA-rated securities for the so-called ‘Economic Recovery Fund’. €500 billion will simply be given away as grants to the worst affected countries to prevent a debt pile-up and much of it is earmarked for ‘green’ and digital infrastructure. The rationale this time around is that, since all Eurozone countries are so deeply interconnected, strong performance for all would also benefit all. Beyond that, it was seen as an act of solidarity of Europeans having each other’s backs and a big win for the EC President, Ursula von der Leyen, who convinced Chancellor Angela Merkel that this was the only way to save the European project from falling apart.

A change of mood in Germany, which has also decided to open its own fiscal taps to support Europe, was the big event that changed the tide of history.

Such ideas have been widely circulated before, but they never came to fruition. A change of mood in Germany, which has also decided to open its own fiscal taps to support Europe, was the big event that changed the tide of history. The proposal still needs to win support from other frugal states, like Finland and Austria, but that is widely expected to happen since this package comes with something for everyone.  A focus on ‘green’ recovery is particularly attractive to electorates and the equitable distribution of the debt burden where beneficiaries pay-up makes it politically viable. July remains a critical month as that’s when Germany takes up the presidency of the EU and the talk on this fund will intensify.

Among asset managers, there has been an underappreciation of the EU economy which, put together, is the largest in the world. The difficulty in moving cash from prosperous regions to transitioning ones has made debt of European countries riskier than its counterparts. This creates a situation where, in spite of having some of the largest, most innovative, and fastest growing companies, both the Euro and European equities have failed to outperform the US. This common bond can be expected to change that. The ‘Eurobond’ offers investors simplicity in investing, high liquidity, and, above all, safety, much like US treasuries or UK gilts. They also make it easier for countries like Italy to raise their own debt as investor confidence improves and lowers bond yields in Italian sovereign debt, diminishing the gap with Germany.

Among asset managers, there has been an underappreciation of the EU economy which, put together, is the largest in the world.

The other major advantage of the proposed recovery fund is how it has become complementary to the European Green Deal. It brings forward billions of dollars of investment to curb emissions forward and could win from the popularity of ESG investing. The European Union as a whole is already producing 20% less CO2 than in the late 1990s, and its businesses, particularly utility companies, are rapidly evolving to a greener world. MEPs in Brussels have urged the EC to put green recovery at the heart of the recovery fund, and the commission in turn said that “Europe after the recovery should be greener and not go back to pre-crisis status quo.” The idea of not just making up for the lost private investment but also redirecting it to public priorities and tackling inequalities is truly policymaking at its best. Its effectiveness of course relies on the execution of this master plan.

The recovery needs to be a start to fixing Europe. The markets will continue expecting more firepower being handed to the EC for stimulus if Europe is going to make up for a decade of laggard growth. There is also a need for greater fiscal consolidation for the Eurozone with more EU-wide taxes to pay for these bonds. This is a sensitive issue, and one that flares Eurosceptic emotions across the continent if not approached with tact. In addition to solving economic problems, the survival of the European project also needs to focus on winning political support. The aftermath of an economic crisis is cultivated for populist political missions, much the like the growing anti-EU sentiment in Italy. The bottom line still remains this: Europe can survive and thrive, given that it acts together.