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.