It is sometimes stated that Europe is built on crises. The COVID-19 pandemic, following Brexit, has broken the taboo on the creation of a long overdue pan-European fiscal policy.
As predicted, the EU took bold steps towards establishing a common bond to finance a fiscal expansion at the center. However, the creation of a safe asset that eurozone banks could invest in to reduce the economy’s sensitivity to adverse macroeconomic shocks has not yet materialized. There is still a possibility of it happening, possibly after another major crisis.
The Recent Package
On 21 July 2020, the European Council adopted a €750 billion measure — equal to around 6.5% of GDP — to fund governments in pandemic-induced distress. Composed of €390 billion in grants and €360 billion in soft loans, the package is financed based on the issuance of EU bonds against the EU budget, with a slight increase in the latter funding the debt servicing.
This initiative came roughly three months after the European Council adopted a €540-billion package — roughly 4.5% of GDP. This included €100 billion for a European unemployment fund (“SURE”), €200 billion in loans to small- and mid-sized enterprises (SMEs) from the European Investment Bank (EIB), and a €240-billion credit line for distressed governments made available by the European Stability Mechanism (ESM).
This came on top of massive national fiscal stimulus, with spending and revenue measures equivalent to 5% of GDP in Germany and 2% in Italy and France. The lending programs add up to 30% of GDP in Germany and Italy and 15% in France. Loans are below the line, so do not affect the deficit but do affect debt.
The fiscal stimulus will help contain the downturn in the wake of the pandemic. However, it adds massive debt both at the national and central levels, raising concerns about sustainability. Repayment of the debt poses a significant question regarding timing, method, and cost.
Given this context, there are three potential scenarios envisaged.
Scenario 1: Fiscal Austerity
The “standard” outcome in the EU is that the fiscal rules — temporarily on hold since the “general escape clause” was invoked in March — will kick back in, requiring member states to adopt severe fiscal austerity for many years. This implication leads to persistent economic headwinds and potentially prolonged European economic stagnation.
Some of the most hard-hit EU member states will probably default rather than accept a strings-attached ESM rescue program, facing potential electoral fallout.
Banks holding much of the debt will face balance sheet problems and may lose market funding, leading national sovereigns to potentially come to their rescue. This sequence weakens their position and could lead to a reprise of the sovereign-banks doom loop that heralded the previous euro crisis. The European Central Bank (ECB) can only step in through targeted bond purchases (OMT) if a country requests an ESM program, which looks unlikely given the politics. Even “standard” quantitative easing (QE) would not pass muster with the German Constitutional Court.
Fiscal austerity undermines public support for the European project, making it an unappealing option for most European leaders. A potential consequence could be the demise of the euro, prompting a gradual unraveling of the EU and the redrawing of the geopolitical map. This may mark the end of globalization as Western Europe remains in the US orbit while their eastern counterparts are drawn into other spheres of influence. The implications for the US role in the world or its system of overseas alliances and the outlook for risk assets globally would be bearish.
Under this backdrop, sovereign spreads could potentially increase, the VIX may spike, euro-denominated equities could plunge, and the outperformance of US banks over their EU peers may continue. US Treasuries would serve as a safe haven, but the dollar’s strength would continue at the expense of developing economies, leading to a potential selloff of currencies, bonds, and equities in certain countries.
EU vs. US Banks: Relative Performance
Regarding the perils of this scenario, it motivates German chancellor Angela Merkel and French president Emmanuel Macron to push for new pan-European fiscal stimulus. However, the plans as conceived might not suffice as long as austerity affects the economy.
Scenario 2: Mutualization
Alternatively, the EU could buy most of the national debt, financing the purchase through the massive issuance of additional joint bonds. This aligns with the safe asset proposal, addressing most of the structural flaws of the current monetary union without a fiscal union.
If this scenario materializes, the euro would appreciate relative to the dollar, and spreads would converge as yields on peripheral debt fall at first and markets recognize the collective responsibility for all of Europe.
In the long term, national sovereign yields across Europe would potentially rise somewhat but remain low. European equity markets would outperform their US counterparts and the euro would improve its status as a reserve currency. If the Fed continues monetizing deficits, the price of gold might reach new highs, demonstrating its negative correlation to the DXY.
Scenario 3: Monetization
If mutualization proves politically unacceptable and austerity becomes the default scenario, the only remaining option is the monetization of national and potentially EU debt by the ECB. The ECB would purchase the bulk of the debt and then cancel most of it.
This debt monetization could save Europe’s banking system and reduce spreads between Italy and Germany, but it could do little to address more fundamental problems. The underlying question is whether loans will reach the SMEs and corporates that need them the most. These policies will do very little to help the real economy in the long run, serving as a poorly concealed attempt to avoid the inevitable: Either Europe forms a United States of Europe fiscal union or abandons the euro altogether.
Under an “either / or” scenario, the long-term implications for financial markets will be more binary, potentially leading to a rise in yield spreads or a compression. Initially, monetization should be marginally positive for equity markets, with the ECB likely to act as a lender of last resort. Gold should set new highs on the back of surging demand. Under a worst-case scenario, non-cash alternatives such as gold, certain real assets, and possibly cryptocurrencies could gain strength.
Wrapping Up
Fiscal austerity on the order of 20% of GDP is highly unlikely. The future is likely to lean more towards mutualization and monetization than austerity, with potential positive implications for the euro, European sovereign debt markets, and European equity markets in such a blended scenario. If further integration continues and Europe implements structural reforms, EU equities could outperform by a significant margin, and gold prices should hold up as central banks continue to monetize their deficits.
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The views, opinions, and assumptions expressed in this paper are solely those of the author and do not reflect the official policy or views of JLP, its subsidiaries, or affiliates.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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