This recovery plan is a small step for fiscal integration, but a giant leap for Europe and European assets.
Listen to On the Minds of Investors
Over the past ten years, European equities have underperformed the U.S. by 174%pts in U.S. dollar terms. For years, the valuation argument has been in Europe’s favor, but there was always the nagging question of whether this discount was justified – and if anything would ever change it. The argument was that while Europe had developed a strong monetary union over the past decade, it failed to have a fiscal union, which would always hinder the region’s growth and cap the valuation of its assets.
In a recent post, we argued that there are 5 reasons to re-consider investing in European equities. One of the arguments was that we were seeing signs that the social distancing recession was providing the push for a more fiscally integrated Europe. This week, the region took a giant step in that direction with all 27 leaders of the EU member states approving the European Commission’s proposal for a joint COVID-19 crisis recovery fund.
The details include a €750bn recovery package (worth 5.4% of GDP), of which 52% will be grants and the remainder loans. There are a few transformational aspects: 1) it will be financed by the large issuance of common EU bonds, 2) the debt will be serviced by the EU budget, and 3) the funds will be allocated to countries based on need, not on contribution to the budget.
In practice, this means that high-debt countries like Italy, Spain, Portugal and Greece will receive more in funds than they contribute, while high-income countries will be net contributors. Crucially, high debt countries will receive these funds financed by the European Commission’s AAA rating, instead of by their own much lower ratings. While this is exactly what the United States does for its states on a regular basis, European Union countries had never agreed to this level of fiscal federalism before.
Countries across Europe now have an equal shot at a strong recovery out of the COVID-19 crisis, instead of high-debt countries being weighed down by their fiscal constraints. In addition, there is now a lower risk that populations will become frustrated by the lack of benefits of the union and will vote to leave the project altogether. This lower break-up risk means that European assets need to embed less of a risk premium, allowing for higher equity valuations, lower bond spreads and a stronger currency.
Indeed, this recovery plan is a small step for fiscal integration, but a giant leap for Europe and European assets. While there has been some more optimism around European equities over the past two months, it is far from an overbought asset class. There is still a lot of ground to make up the 240 billion USD in outflows out of European equity funds over the last 30 months.
One small step towards fiscal integration, one giant leap for Europe
Beneficiaries vs. contributors of EU recovery fund, EUR billions, labels are % of GDP