By Sabrina Khanniche, Senior Economist, Pictet Asset Management.
It was Milton Friedman who said “only a crisis produces real change.” How ironic, then, that the Nobel Laureate’s observation now appears to apply to the euro zone – a project he famously described as economic and political folly.
For faced with a public health crisis and the deepest recession since World War Two, European leaders have fashioned a rescue plan that could, with luck, prove transformative for the region.
Conceived by Germany and France, the new EU recovery fund is revolutionary in several respects. First, it is large. Combined with measures such as the Guarantee Fund for EU businesses and the European Stability Mechanism (ESM), the EUR750 billion package takes Europe’s collective spending power to about EU1.2 trillion, or 6.5 per cent of its GDP. In every sense, it is a potent response to the pandemic shock.
Second, it is ambitiously green. Up to a third of the planned investment is to be channelled to projects that will hasten the bloc’s transition to a net zero carbon economy.
"There is every chance Europe could emerge from the pandemic with firmer political and economic foundations in place. "
Third, and most importantly, the scheme embodies collective responsibility.
Specifically, it is predicated on closer fiscal co-ordination and the creation of a euro zone sovereign bond market worthy of the name.
In fact, how the fund is financed is arguably just as important for Europe’s long-term future as the existence of the fund itself. By agreeing to jointly-issued bonds that will later be repaid under the new EU budget and partly though new region-wide taxes, the bloc has taken the first steps towards greater fiscal integration.
The ramifications of this shift are difficult to overstate. Closer fiscal ties would bring economic and political stability to a region that has been sorely lacking in both. A more united Europe will be able to better shape and direct its economic future and carve out a more influential role on the world stage. That will have repercussions for investors: Europe’s stocks bonds and currency could become a bigger feature of international portfolios.
The path to European reform is treacherous, however. Although the deal has won the support of the EU 27, resistance to the recovery fund remains strong, particularly among the Netherlands, Sweden, Denmark and Austria - the region’s ‘frugal four’ economies. An unravelling of the scheme now, or indeed in future, cannot be ruled out. The risk of long political disputes and spending delays is still uncomfortably high.
Even so, with the unequivocal backing of Germany and France, there is every chance Europe will emerge from the Covid-19 pandemic with firmer political and economic foundations in place.
Why a recovery fund is essential
When Covid-19 struck, it hit Europe’s most brittle economies hardest. Italy in particular had long struggled with the after-effects of the back-to-back global financial and euro zone crises of the past decade.
It took until 2017 for Italy’s GDP per capita to fully recover from the 2008 debt crisis1. Its poor competitive position relative to the single currency region’s north, bad demographics and ineffectual governments were all drags on growth.
So with the pandemic sweeping through the country with unanticipated ferocity, overwhelming its richest and most economically productive region, the Italian government faced an immediate economic calamity.
Italy’s trauma looked to be repeated across Europe. Spain, France and Belgium also suffered high infection, hospitalisation and mortality rates. These also happened to be countries that, according to our sovereign risk model, had some of the developed world’s least sustainable debt burdens.
And while other euro zone members escaped the worst of the disease by locking down hard, they also suffered severe economic contraction as whole sectors were put into hibernation for weeks on end.
Daily economic activity across the single currency region plummeted by as much as 40 per cent from before the pandemic and we anticipate an 8 per cent contraction in GDP for the year overall, including an 11.2 per cent peak to trough drop. The need for vast amounts of emergency fiscal stimulus, in the absence of even minimal inflation to lift nominal economic growth, raised the spectre that already high debt loads could rocket to levels that would trigger another existential crisis in the euro zone.
By the end of 2019, Italy’s public sector stood at 136 per cent of GDP. With government revenues falling, and stimulus and welfare spending pushing public expenditure higher, the government is forecast to run a budget deficit of 9.2 per cent of GDP this year. Our base case forecast is that public debt will be 18.8 percentage points higher in 20222. The situation would be even more precarious if government credit guarantees soured. Factor in a corporate default rate of 50 per cent, and Italy’s debt could surge to 177 per cent of GDP in 2022. France and Spain started with a somewhat better state of public finances – each carrying a debt-to-GDP ratio of around 100 per cent in 2019 – but the progression of their indebtedness was on a similar path to Italy’s.
The pandemic, then, laid bare many of the flaws in the single currency project – monetary union without fiscal union and transfer payments would ultimately prove unsustainable. A crisis could potentially tear the bloc apart. But even in the absence of a shock, the lack of coordinated fiscal and monetary policy threatened to stall Europe’s future economic development.
So when France and Germany devised the EUR750m plan, not only did they raise the prospect of a faster, more robust recovery from the Covid-inspired economic collapse. They also edged the bloc closer to its own Hamiltonian revolution – a European version of the fiscal union forged by the US’s first treasury secretary, Alexander Hamilton in 1790.
Fig. 1 - Divergent: sovereign debt dynamics across Europe
Pictet Asset Management short-term sovereign debt risk metric vs debt sustainability score
Source: Pictet Asset Management. Debt dynamic scores are generated by Pictet Asset Management from a number of official indicators, comparing countries relative to each other and to their own trends. Source: Pictet Asset Management, CEIC, Refinitiv. Data are for 2019 for the structural sovereign scores and as of 31.03.2020 for the short-term debt score.
A shot in the arm for infrastructure
A big, jointly-funded stimulus programme could also solidify the single currency region by incentivising investment.
Indeed, the recovery fund could help address one of Europe’s most persistent problems: poorly-maintained infrastructure. According to the European Investment Bank, investment in roads, rail, telecommunication networks and other physical assets stands at just 1.6 per cent of GDP region-wide. That’s the lowest level of capital spending in 15 years. More worrying is that the aggregate figure masks large discrepancies across countries; economies in the Europe’s periphery have invested far less over that time.
Under-investment partly testifies to the effects of recent economic shocks. In the wake of the 2008 financial and euro zone sovereign debt crises, countries with large debt burdens like Italy came under considerable pressure to cut deficits. Mostly, this was achieved by cutting public sector investment. From 2008 to 2013, Italy’s and Spain’s investment rates fell 3 and 6 percentage points respectively to 18 per cent and the euro zone’s average annual rate of investment growth halved to 1.5 per cent. This, in turn, weighed on domestic demand and dragged down growth. A properly focused investment programme that doesn’t further burden weaker economies with yet more debt could help reverse this decline and boost the region’s productivity.
"The recovery fund could address one of Europe's persistent problems: poorly-maintained infrastructure."
There also a strong ecological case for Europe’s clean recovery plan. Studies show the region’s environmental impact is large relative to the size of its population.
A 2017 audit based on the Planetary Boundaries framework – a model that measures a country’s environmental footprint along nine dimensions including land use, carbon emissions and chemical pollution – found Europe makes a disproportionate contribution to global warming and the loss of natural habitats3.
The model estimates the region’s carbon budget for the next 80 years is 70 gigagtonnes (Gt), or 0.9 Gt per year. But with European nations already emitting a total of 4 Gt of CO2 annually, they will have breached that threshold well before 2040. Europe’s record on habitat loss is equally poor. A net importer of agricultural products, it responsible for about 10 per cent of all global deforestation.
The report’s authors warn of a “substantial gap” in Europe’s rhetoric on the environment and its track record.
The anatomy of the recovery fund and future reforms
A genuinely visionary plan but no panacea. That is perhaps the fairest assessment of the recovery fund. An economy of Europe’s size and complexity demands more reform and investment than can be contained in one programme.
Even so, it is difficult to fault the scheme’s ambition and design.
The fund aims to simultaneously address each of Europe’s most serious, and related, problems - economic, structural and environmental – while making a genuine attempt to spread the costs of stimulus as equitably as possible.
The funding mechanism is central to achieving those goals. Approximately EUR400 billion of the EUR750 billion is expected to come in the form of grants rather than loans. Just as importantly, most of that money is earmarked for countries suffering the steepest declines in growth and employment. Under the mooted funding formula, Southern Europe should receive a generous subsidy, paid for by bonds issued by the entire bloc that will not need to be redeemed until 2028 at the earliest. An additional EUR200 billion of loan guarantees will be also be distributed according to economic need.
In this regard, the recovery fund sets a template for how the responsibility for the region’s debt obligations can be more evenly distributed across the bloc. The hope is that, by sharing risks in this way, the economic disparities that exist between the richer North and the poorer South will begin to disappear. According to the European Commission’s own calculations, the recovery fund should lift EU GDP by some 2.3 per cent by 2024 in aggregate, but with peripheral economies experiencing a stronger boost.
Fig. 2 - EU reform priorities
Source: Pictet Asset Management
The plan also deserves praise for its environmental ambitions. The EU has already committed to reducing greenhouse gas emissions by 40 per cent compared to 1990 levels by 2030. In setting that target, Brussels also pledged to make significant investments in environmental technology. The recovery fund is part of that strategy. More than 30 per cent of it is to be set aside for green projects, with most of the money flowing to sectors and technologies that offer the quickest route to carbon neutrality. This will include investments in renewable energy, clean hydrogen, e-mobility, energy efficiency technology and sustainable buildings.
For all this, it would be wrong to describe the recovery fund as a cure-all. The difficulties facing economies in the region’s periphery will take years to overcome.
According to research from the Centre for European Policy, Germany’s GDP per capita has increased 10 per cent as a consequence of joining the euro while Portugal, Italy, Greece and France, by contrast, have suffered a decline in prosperity in the order of 20 to 35 per cent. Closing these gaps will require more work.
Still, the plan puts Europe on a path to deeper reforms. It could, for instance serve as a spur for the full integration of the region’s capital markets and the creation of a banking union.
A bloc-wide deposit guarantee scheme would be more likely with the recovery fund in place. So too would a harmonisation of the region’s insolvency laws and securities regulations.
The recovery plan might also revitalise efforts to restructure the EU economy which, as Covid-19 has brutally laid bare, is overly reliant on exports.
That would involve stimulating domestic demand through measures such as universal basic income or social security across the bloc, reduced income tax, higher levies on wealth, VAT cuts and direct transfers to low income households.
A rebalancing would also require better-targeted public investment. An immediate priority is digital technology. The EU's digital infrastructure lags that of both the US and China by a considerable margin. To its credit, the recovery fund contains provisions for extra spending on technology. But if the region is to compete globally, additional investment is required. This should include spending to improve connectivity and strengthen Europe’s presence in digital value chains in areas such as artificial intelligence, cybersecurity, data and cloud infrastructure, 5G networks, quantum computing and blockchain.
"The plan puts Europe on a path to deeper reforms. It could serve as a spur for the full integration of the region's capital markets."
Ecological transformation could gather pace too. With its Green New Deal, the EU aims to create over 700,000 new jobs by 2030.
Its targets include:
- Energy, with priority given to renewable energy (including clean hydrogen), energy efficiency and smart power grids
- Transport, particularly promoting electric vehicles, improving train links and urban public transport, and discouraging air transport for distances of less than 1,000 km
- Biodiversity and the protection and restoration of natural environments
Yet, according to the European Commission, the bloc needs an additional EUR260 billion per year in green investment if it is to achieve its 2030 target for greenhouse gas emissions reductions.
More ambitious cuts of 50-55 per cent – currently under discussion – would take that figure to at least EUR300 billion.
To this end, the EU may need to relax fiscal rules further when it comes to public investment linked to climate change adaption and prevention. It also needs to encourage private investment with clear long-term targets as part of reforms contained with the EU Action Plan on Sustainable Finance.
Carbon permits are already encouraging companies to cut emissions and invest in cleaner tech. However, pricing must be revised so that incentives for change are strong across all sectors. Revenues from permits can then be used to further develop the low-carbon economy via public investment in low-carbon infrastructure, funding of R&D and innovation.
Companies that succeed in achieving much lower emissions than is standard in their industry can be rewarded with subsidies – a policy which will have the added benefit of helping create a competitive advantage for European industry in the global low-carbon economy.
Investors will view Europe’s €750bn pandemic recovery plan with a mixture of hope and apprehension. Apprehension because even though the scheme has won the approval of the EU 27, there can be no guarantees of a smooth journey from this point. Keeping sceptics such as Austria, Denmark, the Netherlands and Sweden on board will be fraught with difficulty.
They may have secured key concessions but the region’s “frugal four” economies will demand constant scrutiny of how the money is spent. Fund recipients can expect zero tolerance if they backpedal on reforms, which could mean further political disputes and spending delays.
Still, hope is in sufficient supply. Much of it comes in the form of Franco-German resolve. There is every possibility that Europe’s two economic powerhouses — upon whose shared vision the plan is built — succeed in bridging the gaps.
Indeed, whenever the two have worked in tandem, they have proved a formidable pairing. It was their alliance that kept Britain out of the European Economic Community for years in the 1960s, and it is to their collective effort that the euro owes its very existence. Given that the frugal four account for just one-tenth of the bloc’s total population, it is a fair bet that Paris and Berlin — which speak for almost two-fifths — will prevail.
If they do, they may end up transforming the investment landscape. Europe’s bonds, currency and stocks could become much bigger features of international portfolios.
Bonds, in particular, could benefit. That is because the fiscal co-ordination at the core of the plan will create a sovereign fixed-income market for the eurozone worthy of the name.
Currently, less than a quarter of European sovereign and supranational bonds carry triple A ratings. The recovery programme could increase the amount of top-rated debt to some €1.4tn.
Europe’s riskier sovereign bonds might also become sturdier investments — not least if the recovery fund were to succeed in sharing the costs of economic reconstruction and easing the pressure on the most indebted nations. With the risk of the bloc’s break-up contained in this way, southern European government bonds could become core holdings for a broader circle of investors.
Fig. 3 - European stocks score better than peers on ESG
% stocks in MSCI World Index that achieve top-quintile ESG ratings, by region, weighting-adjusted*
Source: Pictet Asset Management, Refinitiv, Sustainalytics. Data as of 30.06.2020 *Percentage is a relative weighting. It is calculated in the following way. First, we calculate the percentage of stocks from each region that attain top-quintile scores. From that percentage we subtract the MSCI weighting for each region (62 per cent for the US, 10 per cent for the Euro zone and so on). We then perform the same calculation for the bottom quintile. We then subtract the bottom quintile proportion from the top quintile proportion to arrive at the final figure.
A more stable Europe and a deeper bond market would bring significant benefits for the euro, too. Since its inception in 1999, the single currency has lived in the shadow of the US dollar. Its failure to mount a genuine challenge to the greenback’s status as a reserve currency has in part reflected the lingering risk of the bloc’s break up. The issuance of a new breed of pan-European triple-A bonds changes the calculation. Greater political and economic stability should enhance the euro’s appeal among international investors and central banks. According to our model, the euro is trading 16 per cent lower against the US dollar than is warranted by economic fundamentals. What is more, it is also under-represented in central bank reserves relative to its economic heft, accounting for just 20 per cent of the total held compared to the US dollar’s 62 per cent share. In the absence of a recovery fund, the euro can in any case be expected to appreciate by some 2 per cent per year against the dollar over the next five years, according to our currency model. With the fund in place, the appreciation could be even stronger.
Europe’s stocks should also enjoy a re-rating. In the past 20 years, they have consistently traded at a steep discount to their US counterparts. Over that period, US stocks’ price-to-book ratio has, on average, been some 50 per cent higher. Even at its lowest point, during the 2008 financial crisis, the US premium was still a considerable 20 per cent. The valuation gap is not an anomaly. It testifies to three fundamental differences between US and European markets. The first is sector composition. In other words, the US is home to a far larger number of faster-growing, tech-oriented companies – there are no European versions of Amazon, Google or Apple. The second is America Inc’s superior profitability. For various reasons, among which softer tax and regulatory regimes, US companies have traditionally delivered a higher return on equity than European firms: 15 per cent vs 10 per cent in the years since the 2008 credit crisis. The third discount factor is political. European stocks’ valuations have embedded the risk of a euro zone break up, particularly over the past decade.
The EU recovery fund promises to reduce some of these disparities. By channelling investment into tech-oriented ‘green’ sectors, it could revitalise Europe’s new economy firms. Aided by the EU’s green regulations, European companies are already making considerable advances in renewables, smart city infrastructure and energy efficiency technology. With additional public and private investment, the region could become a global leader in these and other fast-growing environmental industries (non-European firms would likely benefit from the investment too, but to a lesser extent). In time, this could transform the investment profile of European equities. Growth-oriented investors who have traditionally been drawn to the US could come to see European stocks as viable alternative.5
More generally, if Europe also succeeds in nurturing a corporate culture that is more attuned to the needs of the environment, then its stocks could command a considerable premium. European firms already score better than their peers when it comes to incorporating environmental, social and governance (ESG) factors (Fig. 3). That bodes well for investors. A growing number of studies show that higher ESG scores are positively correlated with equity returns.
Lastly, the fiscal co-ordination at the fund’s core dramatically lowers the probability of the euro zone breaking up. This, in turn, should reduce the ‘political risk’ inherent in European stocks. So investors would do well to embrace the EU’s radical change of direction. Betting on the old continent might soon deliver a new kind of reward.
 At constant dollar exchange rates.
 Standard public debt dynamics equation with the following assumptions: fiscal revenue is a function of both past and current nominal GDP growth; govt expenditure (ex-interest payments) adjusted lower in 2021 & then frozen; average cost of debt is unchanged at its 2019 level
 The European environment —state and outlook 2020, European Environment Agency; Hoff, H., Häyhä, T., Cornell, S., Lucas, P. 2017. Bringing EU policy into line with the Planetary Boundaries. Stockholm Environment Institute (SEI) Discussion Brief; Tracking progress towards Europe's climate and energy targets, EEA 2019; Is Europe living within the limits of our planet? EEA Report No 01/2020. See also: https://www.bafu.admin.ch/bafu/en/home/topics/economy-consumption/economy-and-consumption--publications/publications-economy-and-consumption/is-europe-living-within-the-limits-of-our-planet.html
 According to our calculations, the gap in Italy's debt servicing cost-nominal economic growth rate will be 2 percentage points by the end of 2022.
 Under this scenario, the valuation gap between US and European stocks - as measured by the equity risk premium - could narrow considerably. The US equity risk premium is currently at 6.5 per cent while that for German stocks is at 8.2 per cent. Our strategists expect this risk premium to compress over the next five years largely on the back of a re-allocation among international investors from the US to Europe. The recovery fund could strengthen this trend.