United Kingdom, Intermediaries

Recovery Fund: a tailwind for euro assets

Macro Strategist Jens Larsen argues that the Recovery Fund marks a big change in the EU’s approach to fiscal policy which should enable euro area equities to outperform the US over the next year.

The views expressed are those of the authors at the time of writing. Individual teams may hold different views. The value of your investment may become worth more or less than at the time of original investment.

The EU’s new Recovery Fund establishes a joint fiscal capacity and will support EU investment in the coming years, particularly in the transition to a greener, more digital economy. This package is in stark contrast with the lack of support during the recovery phase after the European sovereign crisis. It appears to mark a big change in the way Germany and the EU will approach fiscal policy, lowering the risk of an untimely pro-cyclical fiscal tightening. I believe this coherent political and policy response reduces the risk of a euro-area crisis in the coming years and of Italy departing the euro.

In my view, the package provides a tailwind for European equities, which I expect to outperform US equities over the year ahead. Together with the asset purchase programme of the European Central Bank (ECB), it should help to contain sovereign and credit spreads, support the euro and steepen the yield curve.

What was agreed?

The European Council has finally managed to close a deal on the €750 billion EU Recovery Fund. It has also reached agreement on the €1.1 trillion seven-year EU budget framework for 2021 – 2027.

In my view, this package:

  • Maintains the overall size proposed for the Recovery Fund, even though the proportion of grants (as opposed to loans) was reduced from €500 billion to €390 billion.
  • Enables issuance of long-dated EU bonds to finance the expenditure.
  • Will give the EU dedicated revenue streams, starting with a tax on non-recyclable plastics in 2021.
  • Strengthens conditionality on usage of the resources, requiring national governments to focus on green and digital transitions.
  • Introduces a mechanism for raising concerns about respect for the rule of law, even if that mechanism is weak.

Why is this important?

Stronger joint fiscal capacity — The agreement will enable the EU to borrow at a significant level, creating serious EU fiscal capacity. The repayment of the loans is in the far future, and more of the burden of that repayment will be carried by the wealthier, less indebted countries.

Fiscal support in the recovery phase — The package will help finance investment in key priority areas in the recovery, rather than general government spending. The fiscal multiplier could well be significant, boosting growth. The size of the fiscal impact is driven by the gross, not net, contributions.

Space created for individual sovereigns — While the package provides little immediate support for spending in 2020 or early 2021, it enables the sovereigns themselves to respond less tentatively. I think that Italy and Spain can now be more aggressive in their fiscal response because sovereign spreads are contained and confidence is underpinned, enabling them to issue large quantities of debt. They also know that the European Commission is not going to ask them for fiscal consolidation in 2021 or 2022.

Strong political and policy signal — Even though the EU Recovery Fund is not a permanent mechanism, it marks a big change in how the EU approaches crises. The Recovery Fund allows for a joint fiscal response to a large economic shock. It confirms a shift in German political opinion, with new support for the ECB’s asset purchase programme, for (limited) fiscal transfers and for countercyclical fiscal policy.

What the deal does not do

The deal does not address the legacy debt issues.

Individual sovereigns still largely have to cover the very significant fiscal outlays in the near term.

While this marks a stronger response for an EU-wide crisis, we still do not know how a fiscal crisis in Italy would be dealt with. In such an event, the contentious credit facilities of the European Stability Mechanism would still be the first line of response.

The package does not in itself improve structural policies. There is an important emphasis on green spending and on digitisation, but no further macroeconomic reform conditions are attached to the distribution of funds.

What are the implications for euro assets?

The agreement is not a surprise, but I don’t think the current pricing of European risk assets reflects the reduction in risk that this package entails. So this is a key element of my expectation that European equities should outperform US equities over the year ahead.

The agreement will establish the EU as a significant issuer of debt on a fairly large scale. In my view, it will make EU bonds a very close substitute for German bunds and will exert upward pressure on long bund yields. The package also provides support for nominal demand, which I think should steepen the yield curve.

The agreement should lead to a reduction in sovereign risk premia. I expect this to help contain sovereign spreads and lead to continued upward pressure on the euro.

RECOMMENDED FOR YOU

EMs: With great challenges come great opportunities
From health and wellness to climate change and more, the COVID-19 crisis has spawned or accelerated compelling investable themes across a range of EM countries. Against that backdrop, four of Wellington’s EM equity portfolio managers share their latest insights.
October 2020
EMs: With great challenges come great opportunities
,
Tracking the green transition in emerging markets
COVID-19 has ratcheted up environmental debates across emerging markets and highlighted the intersection of those concerns with local supply chains and infrastructure gaps. Equity Portfolio Manager Liliana Castillo Dearth looks at China as a case study.
October 2020
Tracking the green transition in emerging markets
,
The dawn of divergence and the art of subtlety
Multi-Asset Strategist Nick Samouilhan highlights the key divergences we should start to see as fundamental differences between companies, sectors, and countries begin to matter more.
October 2020
The dawn of divergence and the art of subtlety
,
Why should investors study climate science?
Our director of sustainable investment discusses our partnership with Woodwell Climate Research Center and the tools we are developing to help investment teams and clients understand the economic impacts of climate change.
October 2020
Why should investors study climate science?
,
<span>Top of Mind</span> Time for a new playbook on inflation and active management?
Are fiscal and monetary policy setting us on a course for inflation? How has the COVID-19 crisis altered the backdrop for active management? Multi-Asset Strategist Adam Berger offers his take, as well as thoughts on real assets, value stocks, the technology sector and alternative investments.
October 2020
Top of Mind Time for a new playbook on inflation and active management?
,
Global ESG Research Update — Looking inward on our diversity practices
Our team describes insights gained during a firmwide panel discussion with D&I officers from leading global consumer companies. We also provide an update on our ESG engagement and proxy voting activity in the quarter.
October 2020
Global ESG Research Update — Looking inward on our diversity practices
,
Allocating to China — a deeper dive by asset class
Learn why we believe there is a strong case for increasing allocations to China across multiple asset classes.
October 2020
Allocating to China — a deeper dive by asset class
,
UK equities: Brexit uncertainty keeps me on the sidelines
As the Brexit negotiations drag on, Macro Strategist Jens Larsen weighs up the possible outcomes and explains why he is cautious on UK equities.
October 2020
UK equities: Brexit uncertainty keeps me on the sidelines
,
We use cookies to improve your experience on our website. To accept cookies click Accept & Close, or continue browsing as normal. For more information, visit Cookies & Tracking NoticE.