European Union: A Recovery in the Making

European Union (EU) negotiations over the 2021-2027 budgetary framework and recovery plans may have been tough, but Europe looks to be back on track, not least because of a fresh and vastly more dynamic leadership at the EU Commission.

Binding the two spending vehicles together gives the EU Commission greater leverage over EU-wide spending, while the EU Council used the negotiations to tighten up budgetary controls.

The plans should help calm the acrimony that arose over differences on how to fund the pandemic recovery as well as pave way for the Commission to launch new and interesting projects – of which climate will take a substantive part. This reinforces environmental, social and governance (ESG) factors as a key component to investment in the EU. Resilience – or bringing supply chains closer to home – is another focus.

But all of this is subject to parliamentary approvals and the European Parliament has already objected to a number of cuts to the 2021-2027 framework agreed during the EU Council Summit.

 If all goes according to the EU Council’s decision, the Recovery Fund is to be spent alongside the Multiannual Financial Framework (MFF, Figure 1) although it will be funded in a different way. The Recovery Plan will be financed through borrowing on the fixed income markets rather than through contributions from member states or via imposing a levy on their tax revenues.

EU Council’s Recovery Plan Spending Conditions

• Gross National Income (GNI) key to determine income transfer amounts; EU Commission to set rules and 2020 GDP declines to be accounted for
  
• The October EU Council to reach agreement on each country’s spending plans with firm conditions set for implementation
  
• Green and digital transitions prerequisites for a positive assessment of these spending plans
  
• The climate target to account for 30% of the combined MFF and Recovery Plan

Market Implications

We believe that the deal could be perceived as helping toward stabilizing member states’ macroeconomic and political environments as well as laying the foundation for a more meaningful structural change in the coming years.

Quantitative easing will remain a backstop for fixed income markets throughout next year and the deal should help ease pressure on spreads on the periphery. Strong demand for high-quality debt is expected to continue. We would therefore expect healthy demand for a new safe asset – worth approximately 5.5% of EU GDP – even if it is classified as a supranational bond rather than as a sovereign issuance.

Where the euro is concerned, it has been a beneficiary of US dollar weakness on the back of poor COVID-19 handling in the United States alongside concerns around November’s Presidential election.

The new funding requirement could help retain capital in the euro area and sentiment could even help propel EUR/USD above 1.20 in the coming year¹ . Note, the euro area continues to run a large current account surplus on the balance of payments (Figure 3)².

Longer-Term Perspectives

Certain sectors should look more attractive, although for longer-term investors, much will depend on whether structural reforms are implemented, including addressing flaws in the eurozone’s design. In our view, there is impetus, not least in a more dynamic EU leadership, to make this deal a new baseline rather than as a temporary palliative.

The inability to fully implement the banking union is a major flaw in the eurozone’s design. Reform would enable banks to further support lending, while securitization would help them get a grip on non-performing loans and hence help to promote economic recovery as well as give a boost to valuations: Price-to-book valuations in the financial sector average 0.7x, while the same average 0.5x on the periphery.

It was also disappointing that the Capital Markets Union initiative was not mentioned. The initiative should help shift a proportion of corporate financing needs onto equity markets, help small and mid-size enterprises access capital across Europe and make for less corporate reliance on debt financing. It should also give investors greater choice in stock selection and the EU’s ESG targets could also be better expressed.