EU gears up for its next challenge

This week’s online meeting of the European Union’s members to debate the proposed €750 billion COVID-19 recovery plan is vitally important economically and politically. For progress to be achieved and help offered to those who need it, amid predictions that EU GDP will drop by 8–12% in 2020, all 27 nations must agree on:

• the amount of money to be spent, on top of an EU budget of some €1.1 trillion (itself a matter of some friction between member states);
• the conditions for awards of the capital available, which appear to include both green and digital criteria for would-be recipients;
• how the money is to be spent, and the mix between loans and grants; and
• how and when the money is to be repaid and over what time period, starting in 2027.

The discussions are therefore an opportunity to present a united front, tackle the viral outbreak and shore up the EU edifice at the same time, just as the Brexit negotiations with the UK start to heat up again.

Coming of age

“From the narrow perspective of investing in stock markets, it seems that global capital is yet to be fully convinced by the merits of the European project.”

From the narrow perspective of investing in stock markets, it seems that global capital is yet to be fully convinced by the merits of the European project. The sterling-denominated performance of the Stoxx Europe 600 index ranks it seventh out of eight in capital terms since the euro came into being on 1 January 1999.

This poor performance may reflect the lingering effects of the debt crisis that first boiled over a decade ago, as well as the difficulties of providing a solid financial platform with which to support political union, in the absence of fiscal and banking union to support a single currency and unified monetary policy.

EU stock markets have lagged badly since 1 January 1999

Source: Refinitiv data. Capital return in sterling terms. *MSCI Africa/Middle East since inception in September 2003.

It may also reflect the different aims and needs of the 27 member states which are again becoming apparent as the recovery plan and budget come up for discussion.

The most serious questions of the plan are being asked by the so-called Frugal Four of Germany, Denmark, Austria and Sweden.

Failure to agree, in the twenty-first year of the existence of the single currency, would raise existential questions about the euro and the EU’s purpose and usefulness. Government is there to provide assistance in times of crisis above all others and, were the EU to fail to offer help to those nations which COVID-19 has treated most cruelly – notably Italy and Spain – then scope for further local disaffection with the supra-national powers in Brussels is considerable.

“Those nations which COVID-19 has treated most cruelly – notably Italy and Spain – suffered the most in the wake of the debt crisis that started in earnest just under a decade ago. Stock markets clearly believe they have not enjoyed anything like the same degree of economic benefits from monetary union as Germany.”

After all, these countries suffered the most in the wake of the debt crisis that started in earnest just under a decade ago. Stock markets clearly believe they have not enjoyed anything like the same degree of economic benefits from monetary union as Germany. (Eagle-eyed investors will note that two of the three best-performing developed European stock markets since the euro’s launch do not even use the single currency).

In stock market terms, the north looks like a clear winner under the euro compared to the south

Source: Refinitiv data. Capital return in local currency terms.

Great divide

This north-south divide can be seen in another way, via the TARGET2 payments mechanism.

TARGET stands for ‘Trans-European Automated Real-time Gross Settlement Express Transfer’ system. In essence, the system is there to help balance trade flows but it could also reflect capital flows. Supporters argue that the TARGET2’s smooth functioning shows that it balances out the capital needs of the EU’s member nations. Sceptics assert that TARGET2 merely highlights huge capital flight from the south to the north and Germany in particular.

Germany’s TARGET2 surplus is still swelling even as French, Spanish and Italian deficits grow

Source: European Central Bank

No harm is done – unless an EU member defaults or drops out of the monetary union. Then those which have a positive balance are on the hook for the deficits of the member in the red. This may be why the €750 billion recovery plan alarms the Frugal Four, as they fear it could be the first step to debts being aggregated and funded at EU level, potentially leaving them to subsidise what they see as the spendthrift southern members.

“The European Central Bank is doing its bit to keep the plates spinning and, as is the case elsewhere, quantitative easing (QE) is boosting equity and bond markets to at least create some kind of feel-good factor.”

The European Central Bank is doing its bit to keep the plates spinning, as it holds headline interest rates at zero and its €650 billion expansion of the Pandemic Emergency Purchase Programme (PEPP) to take the total to €1.35 trillion. As elsewhere, that quantitative easing (QE) largesse is boosting equity and bond markets to create some kind of feel-good factor.

More QE from the ECB boosts European equities

Source: European Central Bank, FRED – St. Louis Federal Reserve database, Refinitiv data

But whether QE provides a lasting solution is unclear. The cost of meeting each crisis – 2007–09, 2011–15 and now COVID-19 – is becoming ever greater each time. The euro is under less scrutiny than it would be, even if has lost 84% of its value against gold since its launch, because sterling, the yen and the dollar are also at the mercy of identical monetary policies (and all are down by more than 80% against the metal, too). Investors may not welcome another round of patch fixes and last-minute fudges from the latest series of talks, especially if they only serve to stoke further support for anti-EU parties in the south, should those nations start to feel neglected again.