Unpacking the EU’s New COVID Fiscal Response

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 budget, including €750 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 would come from bonds issued by the European Commission (EC), and repayment would be a line item in the EC’s budget for the next 38 years. As for the new spending money, troubled countries would receive it gradually in 2021, 2022 and 2023, which is predictably driving chatter that the assistance is too little, too late. In our view, this is just one more example of the Pessimism of Disbelief—the perpetual search for bad news that accompanies new bull markets. Europe doesn’t need some massive fiscal stimulus or other quasi-governmental crutch to recover from the recession that began in Q1. Continuing the reopening process, no matter how gradually, should suffice. With expectations still so dreary, it shouldn’t take much for results to positively surprise.

One big talking point that isn’t so relevant for markets, in our view, is whether the new bonds would qualify as collectively issued EU debt. In our view, they wouldn't—an assessment most pundits seemingly share. They wouldn't be issued, serviced and guaranteed jointly by EU states. Rather, the issuer would be a supranational organization—a bureaucratic institution—with its own budget. Funding for that budget comes from EU nations, with each paying a share relative to its size. So these bonds wouldn't really be a statement of collective creditworthiness, and they wouldn’t replace member-states’ national bonds. In other words, this plan doesn’t aim to turn the EU into a federalized fiscal transfer union like the US. Whether or not this is a good thing is a long-term academic issue that many have debated for years, not anything for markets to deal with in the here and now. This deal simply means that academic debate can continue. How enjoyable.

As for the more immediate implications, on the one hand, 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 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. But to the extent the assistance eases these fears, so much the better.

This being a new bull market, however, fear seems to have morphed rather than faded. Most coverage we encountered added up the money Italy would receive, compared it to how much 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, 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. Q2 GDP will probably be lousy, as those monthly data didn’t turn positive until late in the quarter, but markets are good at seeing through such broadly anticipated timing issues.

Some 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 stocks. Tourism revenue usually flows to hotels—some corporate, some mom-and-pop—and local retailers and restaurants. In other words, primarily small businesses, not publicly traded companies. Nearly one-third of MSCI Italy market capitalization is Utilities. Financials is just behind it. The 13.4% Consumer Discretionary weighting is primarily automakers.^[i] Spain’s breakdown is similar, minus the automakers. Neither nation’s market has material exposure to leisure and hospitality. The sectors that do feature prominently 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.

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 returns to normal, that assistance becomes 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 markets don’t need immediate. They look 3 – 30 months ahead, and as new bull markets race ahead, stocks 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 envision 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.