As May ticked to a close, the EU announced a coronavirus relief proposal including debt issued jointly by member-states—an expansion of the one France and Germany mooted earlier in the month—as part of its €1.85 trillion 2021 – 2027 budget. Many financial commentators we follow treated it as a watershed moment. But in our view, this reaction looks overstated and hasty. Based on how big issues like this normally go in the EU, the budget likely faces a long, uncertain road to passage, with a lot of compromise along the way. Moreover, it doesn’t look much like stimulus to us—and we don’t think its passage or rejection should materially affect the pace of Europe’s economic recovery or the length of the bear market (long, fundamentally driven equity market decline of -20% or worse).
The budget’s key plank—and the piece that drew so many headlines—is a proposed €500 billion in grants and €250 billion in loans for EU member-state governments. The grants and loans would target those nations (especially Italy and Spain) with less-sound finances and larger COVID outbreaks than many northern European countries. The apparent goal is that, by easing perceived fiscal pressure, they would bolster and encourage national coronavirus response efforts.
The purportedly groundbreaking part is the financing. Funding for the EU’s budget currently comes from member-states’ required contributions, import duties and a portion of each member’s value-added tax. Initially, funding for this far more expansive budget would come from €750 billion in debt issued by EU member-states as a collective entity, which has never happened before. To pay off this debt down the road, the EU would also levy a raft of new taxes. These include a tax on companies the EU classifies as significant beneficiaries of access to the EU single market—most likely multinational companies based outside the EU; a digital transactions tax on companies with a “significant digital presence,” in the event ongoing OECD efforts to develop a global digital tax fall short; and a “carbon border adjustment tax” on imports from countries with less strict emissions controls than the EU.[i]
The proposal tries to head off what many commentators call a two-speed recovery from COVID-related restrictions’ economic devastation, in which the harder-hit Southern European nations become permanently poorer than Northern. These concerns aren’t new—similar worries have circulated amongst the commentators we follow for years since the 2008 – 2009 financial crisis and the eurozone’s 2011 – 2013 regional recession. They underpin recurrent fears of things like the common currency splintering, since its rules and architecture prevent weaker, more indebted regions from spending more in an effort to bolster growth. The EU’s budget aims to fix that by acting as a temporary fiscal transfer union—sharing debt and tax revenue on the coronavirus response. It also strikes us as an attempt to push through long-stalled EU policy goals. Debate over what many commentators describe as completing the monetary union through sharing debt has swirled since its inception, whilst discussion of some other issues, like the digital tax, has persisted for years.
Whatever you think of the plan’s goals, in our view, here is what it isn’t: stimulus. Fiscal stimulus aims to jumpstart demand during a recession by creating it where it didn’t exist. Typically, this means new government spending on infrastructure projects and the like, which then ripples through the private economy as the money is spent and re-spent. By contrast, as detailed in the draft budget, the EU’s plan would mainly shore up member-state public finances. Supporters hope this would free up those governments to spend, but this isn’t assured, as it depends on national governments’ decision making and response strategy. Plus, most national COVID fiscal response plans under discussion or implemented mainly seek to tide firms and consumers over to better times—effectively acting as bridge loans. That does little to boost near-term demand. Even if this plan passes, relief funds wouldn’t hit until March 2021 at the earliest, per the budget’s timeline. The recovery could be well underway by then.
The budget’s other novel component—taxes levied by the EU as a singular entity—strike us as the opposite of stimulus. Granted, they wouldn’t go into effect immediately, as EU member-state governments would still have to approve and collect them. The EU budget proposes a rollout target of 2024, although national governments could implement them earlier. We aren’t opining on their wisdom as policy, but looming tax burdens don’t seem calculated to encourage commerce. They are more associated with austerity. Consider the digital tax, which would hit EU revenues of global Tech companies with worldwide sales exceeding €750 million annually—principally, large US technology and e-commerce firms. Whilst we don’t think it would be large enough to materially decrease affected firms’ profits, it could influence future decisions about where—and where not—to expand. Vague tax details—like determining where digital revenue was earned or which companies the EU will decide draw enough benefits from EU market access to warrant special taxation—could increase uncertainty, which diminishes risk-taking. That is generally the opposite of what you want when you are trying to jumpstart an economy.
For now, speculating about the budget’s consequences seems mostly like an academic exercise. The proposal may not happen—especially in its current form. The 27-country consensus required for passage seems distant presently, with some northern EU governments already objecting to the grants. Nearly everyone involved and observing seemingly expects extensive negotiations. Even the digital tax, a relatively minor plank of the plan, seems contentious. The EU’s previous attempt foundered on opposition from low-tax countries (namely Ireland and Luxembourg) that benefit from the current system, in which Tech giants pay taxes only to those countries in which they have a physical presence. The US government may also see the move as protectionist and retaliate. When France passed a digital tax last July, the Trump administration threatened tariffs on French imports. A later compromise scuttled both.
Regardless of the budget’s prospects, we don’t think the length of the current downturn and bear market depend on it passing as-is. Our research and analysis shows economies don’t need saviours. Eventually, they resume growing with or without government assistance. Presently, it seems to us the key is how fast businesses reopen and commerce regains a semblance of normalcy. Equity markets’ reaction to the proposal’s twists and turns over the past couple weeks suggests its progress (or lack thereof) may influence sentiment.[ii] However, sentiment is typically fleeting and unpredictable. Hence, we don’t think it should factor into your investment decision-making.
[i] “The EU Budget Powering the Recovery Plan for Europe,” The European Commission, 27/5/2020.
[ii] Source: FactSet, as of 4/6/2020. Statement based on MSCI Europe returns with net dividends.
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