Well that was fast. It took just one summit and five days for EU leaders to settle various disagreements and agree on a €1.8 trillion (£1.18 trillion) budget, including €750 billion (£699.9 billion) in grants and low-cost loans for countries needing assistance with the recovery from COVID lockdowns’ economic fallout. If this plan receives national parliaments’ approval, funding for that assistance will come from sovereign debt issued by the European Commission (EC), and repayment would be a line item in the EC’s budget for the next 38 years.[i] As for the new spending money, troubled countries would receive it gradually in 2021, 2022 and 2023. Accordingly, many of the financial commentators we follow warn that the assistance is too little, too late. In our view, this is just one more example of a phenomenon we call the Pessimism of Disbelief—the perpetual search for bad news that our research shows accompanies new bull markets (prolonged periods of generally rising equity markets). As we will discuss further below, our research suggests Europe doesn’t need some massive fiscal stimulus (meaning, government spending and investment intended to spur economic activity) or other quasi-governmental crutch to recover from the recession (lengthy period of declining economic output) that began in Q1 2020.[ii] We think continuing the process of easing lockdowns and reopening businesses, no matter how gradually, should suffice. With expectations still so dreary, we suspect it shouldn’t take much for results to positively surprise.
One big talking point we have seen that isn’t so relevant for markets, in our view, is whether the new bonds would qualify as collectively issued EU debt—or so-called eurobonds. In our view, they woudn’t—an assessment most financial commentators we follow seemingly share. They wouldn’t be issued, serviced and guaranteed jointly by EU states. Rather, the issuer is a supranational organisation—a quasi-governmental institution—with its own budget. Funding for that budget comes from EU nations, with each paying a share relative to its size. So these sovereign debt securities wouldn’t really a statement of collective creditworthiness, and they wouldn’t replace member-states’ national debt. In other words, this plan doesn’t aim to turn the EU into a federalised fiscal transfer union like the US or the UK, in which tax revenues and debt proceeds are collected at the national level and permanently transferred to states or constituent countries without obligation of repayment. Whether or not this is beneficial is a long-term academic issue that many have debated for years, not anything for markets to deal with in the here and now, in our view. This deal simply means that academic debate can continue. How enjoyable.
As for the more immediate implications, on the one hand, based on our review of financial news coverage, it does seem to shore up sentiment toward Spanish and Italian debt. Every euro in help these nations get from the European Commission is a euro they don’t have to borrow on open markets, which seems to be easing popular concern that either will encounter funding issues and default. Mind you, we always thought that possibility was exceedingly remote, considering their low long-term sovereign yields and reasonable debt service costs.[iii] But to the extent the assistance eases these fears, so much the better.
This being a new bull market (in our view), however, fear seems to have morphed rather than faded. Most financial news coverage we encountered added up the money Italy will receive, compared it to how much Italian GDP is estimated to have fallen, and deemed the new funding insufficient to cement a recovery. This strikes us as rather dubious, as it implies the only way countries can recover from recession is if governments step in with enough money to erase the GDP contraction. In developed economies where the private sector does all the heavy lifting, we think this cuts against history. Especially when the recession’s central cause isn’t a collapse in demand, but the forced cessation of brick-and-mortar economic activity. All evidence thus far indicates that as these restrictions ease and businesses reopen, recovery advances. Recent Purchasing Managers’ Indexes, industrial production and retail sales all show this.[iv] Q2 GDP will probably be lousy, as those monthly data didn’t turn positive until late in the quarter, but in our view, markets are good at seeing through such broadly anticipated timing issues.[v]
Some observers will rightly point out that Southern European nations rely on tourist revenue for a chunk of their economic growth, presenting stiff headwinds as long as COVID reduces international travel. But whether the new money is enough to perfectly offset lost tourism shouldn’t be much of an issue for European shares, in our view. Tourism revenue usually flows to hotels—some corporate, some family-owned—and local retailers and restaurants. In other words, the money flows primarily to small businesses, not publicly traded companies. Nearly one-third of MSCI Italy market capitalisation (the market value, in pounds sterling, of all companies listed in the index) is Utilities. Financials is just behind it. The 13.4% Consumer Discretionary weighting is primarily automakers.[vi] Spain’s sector breakdown is similar, minus the automakers.[vii] Neither nation’s market has material exposure to leisure and hospitality. The sectors that do feature prominently, in our view, depend much more on broad national reopening than whether tourists can return to the Amalfi Coast, hike the Cinque Terre, stroll the beach at Málaga and gaze at the great cathedrals.
We think Europe’s own recent history shows massive government assistance isn’t necessary for a recovery to take root. When the region last endured a recession, during the eurozone’s 2011 – 2013 debt crisis, a recovery began in 2013 even as most eurozone member states were pursuing spending cuts and tax hikes—the opposite of stimulus or assistance. This time around, the ECB and national governments have provided buckets of money for struggling households and businesses, helping them survive a period when containing COVID required the loss of paychecks and revenues. Now, as businesses reopen and life slowly returns to normal, that assistance should become less and less vital. A gradual return to normal lets businesses and households resume standing on their own two feet over time.
It would probably be unreasonable to expect economic output to return to pre-pandemic levels immediately, but our research shows markets don’t need immediate. We think they look 3 – 30 months ahead, and as new bull markets race ahead, equities tend to look toward the longer end of that window. With vaccine progress continuing, research continually raising herd immunity estimates and businesses slowly coming back online, it isn’t hard to envisage life looking much more normal 30 months from now, regardless of how much (or how little) the European Commission lends or grants to member-states that are struggling today. We suggest investors think like markets and focus on that eventually, rather than get hung up on the finer points of Eurocrats’ wheelings and dealings.
[i] Source: Reuters, as of 22/7/2020.
[ii] Source: FactSet, as of 22/7/2020. Statement based on eurozone Q1 GDP and analysts’ expectations for Q2.
[iii] Source: FactSet, Italian Treasury and Spanish Treasury, as of 21/7/2020.
[iv] Source: FactSet, as of 21/7/2020.
[vi] Source: FactSet, as of 21/7/2020. MSCI Italy and constituent sectors’ market capitalisation on 20/7/2020.
[vii] Ibid. MSCI Spain and constituent sectors’ market capitalisation on 20/7/2020.
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