The economic shock of COVID-19 and mounting concerns over climate change have fostered improved coordination among European policymakers. We believe this has reduced left tail risks and set the stage for greater stability over the secular horizon.
Yet like the rest of the world, Europe will likely be tested by a radically different macroeconomic environment. As discussed in our recent Secular Outlook, the pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead appears to be more uncertain and uneven growth and an inflation environment with plenty of pitfalls for policymakers.
Fortunately, Europe seems better prepared than in the past. The European Central Bank (ECB) has strengthened its role as lender of last resort for the euro area sovereign complex, and the €800 billion NextGenerationEU recovery fund (NGEU) has broken the taboo of funding government transfers via common issuance of bonds. The NGEU intends to steer public and private investment toward areas of the economy expected to generate higher real incomes in the future, namely the green and digital sectors. And while NEGU-issued bonds don’t constitute eurobonds in a strict sense, we believe they are an important step in the direction of more fiscal cohesion.
Overall, we expect evolution instead of revolution in Europe. For instance, the prospect for amending the Treaty on the Functioning of the European Union continues to look remote, and political and moral hazard considerations continue to warrant a significant risk premium.
Importantly, though, in economic downturns, Europe appears likely to embrace a more calibrated policy response than it did in 2008 and 2011 – when officials acted less forcefully and with less coordination in the aftermath of the global financial crisis. At a minimum, improved coordination should open up the prospect of a less crisis-prone, more stable euro area over the secular horizon. Indeed, in effect, the COVID shock constituted a massive stress test for the cohesion of the euro area. The policy response has been considerably more convincing than in previous episodes, which bodes well for risk assets.
Germany sets the tone
Economic policies of the new German government, expected to be in place as early as next month, are likely to set the tone for all of Europe and, implicitly, the ECB.
We believe Berlin will pursue a somewhat less dogmatic fiscal stance and explore investments to modernize the country and strengthen domestic demand. However, we do not believe that Germany will turn from fiscally conservative to fiscally profligate. Nor do we expect Germany to run current account deficits at the end of our secular horizon. Germany is likely to maintain the “debt brake,” the constitutional rule instituted in 2009 that limits the federal government’s structural deficit to 0.35% of GDP.
Nonetheless, we expect Europe’s largest economy to look for ways to amend certain elements of the debt brake and seek a somewhat more flexible interpretation of the fiscal rules. That would send a signal to the rest of Europe, in particular with regard to the reforms of the EU Stability and Growth Pact rules, which limit a state’s budget deficit to 3% of GDP and national debt to 60% of GDP.
The rest of Europe is likely to follow a similar approach. We don’t expect radical regime change in reforming the fiscal rules – a process that has already started and will not be concluded until late 2022.
However, we expect the reforms to result in more fiscal leeway, mainly due to the recognition that fiscal consolidation at the expense of investment has not been the optimal strategy for achieving debt sustainability. Case in point: The European Commission last month presented a discussion paper about stability pact reform, which focused on debt repayment schedules. Another proposal from the European Stability Mechanism foresees an increase in the maximum debt ceiling from 60% to 100% of GDP owing to the lower-growth environment, while keeping the 3% deficit ceiling in place.
Overall, the distribution of outcomes has probably shifted toward more spending, the likelihood of fiscal measures playing a greater role in the overall policy mix has increased, and the probability of austerity, particularly pro-cyclical austerity during economic downturns, has decreased. There are also growing challenges – inequality, digitalization, climate – that could compel governments to spend more.
Much of this spending will likely revolve around the NGEU.
Two of the top structural reform and policy priorities of the fund relate to climate change and digitalization. Europe already has robust climate-change policies, and will likely aim to position itself as a global leader.
The NGEU was set up in July 2020 as a temporary, one-off vehicle to issue debt that is not backed by a joint-and-several guarantee – hence, its securities do not constitute eurobonds in a strict sense. Nevertheless, the fund sets a precedent: It sends a strong message and offers the potential to serve, over time, as a catalyst for closer fiscal and political euro area integration, and potentially continental Europe more broadly. Although we believe it is an unambiguously positive development for Europe, it doesn’t necessarily imply reduced need and effort to improve the institutional configuration further, particularly regarding the euro area.
Will additional spending ignite more inflation? Uncertainty is higher given the pandemic shock and the many transformations that will play out over the secular horizon. Yet Europe went into the pandemic with inflation well below the ECB’s price-stability target for an extended period of time. It has also provided less crisis policy support than the U.S., for example, and fiscal policy is likely to continue to be more active in the U.S. and the U.K. than in the euro area. Thus, it remains less likely to us that, over the medium to longer term, Europe emerges from the pandemic with a high inflation problem.
For its part, the ECB over the last two decades has morphed into a more traditional or conventional central bank. Like its peers, it serves as the lender of last resort and buys sizeable amounts of government bonds.
We believe the forward guidance on policy rates agreed in July 2021 as part of the new ECB strategy mainly serves the purpose of preventing the Governing Council from tightening policy prematurely. It offers reassurance to markets that the ECB will likely remain patient and – by tying the Governing Council to the mast and avoiding premature tightening of monetary policy – won’t repeat the hawkish mistakes of 2008 and 2011. The recent episode of monetary and fiscal cooperation offers the prospect for closer policy alignment if need be. There is broad recognition among elected government officials that the ECB should not again be the only game in town, as it has been at times in the past.
Given Europe’s institutional configuration, politics – both on a national and European level – will remain an important driver of financial market volatility. Without doubt, the political situation looks somewhat more stable now than in previous episodes: Anti-euro area rhetoric hasn’t typically paid off in national election campaigns, and more radical proposals have been dropped from most parties’ election manifestos as a result. Nonetheless, politics injects an additional element of uncertainty in a common currency area without common fiscal and political capacities. This uncertainty is likely to be a perennial factor for investors to monitor and manage.
While starting valuations offer limited room for spread compression, and risks to the macroeconomic outlook remain elevated, a less crisis-prone euro area bodes well for risk assets more broadly.
We remain constructive on peripheral spreads, Italy in particular, while focused on obtaining appropriate compensation for political uncertainty.
Given the euro area’s unique institutional structure and differing macroeconomic conditions, we believe yields in the region will remain relatively better anchored compared to global peers, and we are fairly agnostic regarding overall duration exposure.
Finally, we continue to favor European curve-steepener positions, as we don’t expect the ECB to be able to lift policy rates any time soon, while divergent monetary policy could make the euro an interesting funding currency over the medium term.