Timmermans, Y.

van den Noord, P.

English

It is sometimes quipped that Europe is built on crises. And, yes, the COVID-19 pandemic, following on the heels of Brexit, proved powerful enough to break the taboo on the creation of a long overdue pan-European fiscal policy.This is in line with our prediction that when faced with severe crisis, the EU would take bold steps towards establishing a common bond to finance a fiscal expansion at the center. Our other prediction — that a safe asset would be created that eurozone banks could invest in, in lieu of risky national sovereign bonds, to reduce the economy’s sensitivity to adverse macroeconomic shocks — has not come true. It may still happen, but perhaps only after another major crisis

International Migration, Integration and Social Cohesion online publications

UvA-DARE is a service provided by the library of the University of Amsterdam (https://dare.uva.nl)UvA-DARE (Digital Academic Repository)Post–COVID-19 Europe: Three ScenariosTimmermans, Y.; van den Noord, P.Publication date2020Document VersionFinal published versionLink to publicationCitation for published version (APA):Timmermans, Y. (Author), & van den Noord, P. (Author). (2020). Post–COVID-19 Europe:Three Scenarios. Web publication/site, CFA Institute.https://blogs.cfainstitute.org/investor/2020/10/06/post-covid-19-europe-three-scenarios/General rightsIt is not permitted to download or to forward/distribute the text or part of it without the consent of the author(s)and/or copyright holder(s), other than for strictly personal, individual use, unless the work is under an opencontent license (like Creative Commons).Disclaimer/Complaints regulationsIf you believe that digital publication of certain material infringes any of your rights or (privacy) interests, pleaselet the Library know, stating your reasons. In case of a legitimate complaint, the Library will make the materialinaccessible and/or remove it from the website. Please Ask the Library: https://uba.uva.nl/en/contact, or a letterto: Library of the University of Amsterdam, Secretariat, Singel 425, 1012 WP Amsterdam, The Netherlands. Youwill be contacted as soon as possible.Download date:26 Jul 2022Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorEnterprising InvestorPractical analysis for investment professionalsPos–COVID-19 Europe: Three ScenariosBy Yvo Timmermans, CFA and Paul van den NoordPosted In: Alternative Investments, Coronavirus, Economics, Equity Investments, FixedIncome, Future States, History & Geopolitics, Investment TopicsIt is sometimes quipped that Europe is built on crises. And, yes, the COVID-19pandemic, following on the heels of Brexit, proved powerful enough to break the tabooon the creation of a long overdue pan-European fscal policy.This is in line with our prediction that when faced with severe crisis, the EU would takebold steps towards establishing a common bond to fnance a fscal expansion at thecenter. Our other prediction — that a safe asset would be created that eurozone bankscould invest in, in lieu of risky national sovereign bonds, to reduce the economy’ssensitivity to adverse macroeconomic shocks — has not come true. It may still happen,but perhaps only after another major crisis.06 October 2020Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorThe Recent PackageOn 21 July 2020, the European Council adopted a €750 billion measure — equal toaround 6.5% of GDP — to fund governments in pandemic-induced distress. Composedof €390 billion in grants and €360 billion in soft loans, the package is fnanced based onthe issuance of EU bonds against the EU budget, with a slight increase in the latterfunding the debt servicing.This initiative came roughly three months after the European Council adopted a €540-billion package — the equivalent of around 4.5% of GDP. This included €100 billion fora European unemployment fund (“SURE”), €200 billion in loans to small- and mid-sized enterprises (SMEs) from the European Investment Bank (EIB), and a €240-billioncredit line for distressed governments made available by the European StabilityMechanism (ESM).This, in turn, came on top of massive national fscal stimulus, with spending andrevenue measures equivalent to 5% of GDP in Germany and 2% in Italy and France. Thelending programs add up to 30% of GDP in Germany and Italy and 15% in France.Loans are below the line, so do not afect the defcit but do afect debt.The fscal stimulus is robust and will certainly help contain the downturn in the wake ofthe pandemic. But it adds massive debt both at the national and central levels.Moreover, while it may carry its recipients through the frst stages of the crisis, it willburden them with EU loans and add to their market debt, which is probably alreadyunsustainable.Debt will need to be repaid, and the €2.5-trillion question is when, how, and at whatPost–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising Investorcost.The menu of possibilities is limited. We envision three potential scenarios.Scenario 1: Fiscal AuserityThe “standard” outcome in the EU is that the fscal rules — which are temporarily onhold since the “general escape clause” was invoked in March — will kick back in. Thatwill require member states to adopt severe fscal austerity for many years. That impliespersistent economic headwinds and potentially prolonged European economicstagnation.Some of the most hard-hit EU member states will probably default rather than endurethe stigma and potential electoral fallout of accepting a strings-attached ESM rescueprogram.Banks hold much of the debt. They will face balance sheet problems and may losemarket funding. Conversely, national sovereigns may have to come to their rescue. Thatwill weaken their position further and could lead to a reprise of the sovereign-banksdoom loop that heralded the previous euro crisis. The European Central Bank (ECB) canonly step in through targeted bond purchases (OMT) if a country requests an ESMprogram, which looks unlikely given the politics. In fact, even “standard” quantitativeeasing (QE), allocated across issuers of sovereign debt according to the country’s shareof GDP, would not pass muster with the German Constitutional Court.Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorThis fscal austerity scenario will undermine whatever public support is left for theEuropean project. Which makes it a distinctly unappealing option for most Europeanleaders, especially in view of the Brexit debacle. Indeed, such a scenario could promptthe euro’s demise. If Italy or another country leaves, it is hard to see how it survives.The fall of the euro would be a cataclysmic black swan event, one that could catalyzeanother catastrophe: the gradual unraveling of the EU and the redrawing of thegeopolitical map. That would refect a world where globalization has ground to a haltand gone into reverse.Such a realignment could mean a new Iron Curtain. The nations of Western Europewould remain in the US orbit while their eastern counterparts would be drawn intosome other sphere of infuence. What would that mean for the US role in the world or itssystem of overseas alliances? For risk assets globally, the outlook would be bearish.Against this backdrop, sovereign spreads could potentially increase on the back of a routin peripheral debt amid unforgiving bond markets. The VIX may spike and euro-denominated equities, banks in particular, could plunge given how much nationalsovereign debt they hold.This would prolong the outperformance of US banks over their EU peers, which asdemonstrated in the chart below, started to take root during the European sovereigndebt crisis. Hints of a reversal only emerged amid the COVID-19 pandemic and growingPost–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising Investorhope that the EU would form some sort of fscal union.EU vs. US Banks: Relative PerformanceSource: Bloomberg dataUS Treasuries will no doubt serve as a safe haven for a while. Of course, they ofer littlereturn and how long can they provide protection if the US Federal Reserve keeps onmonetizing defcits? Since the euro is by far the largest constituent of the DXY index,which measures dollar strength, the DXY will continue its upward trend and the recenteuro appreciation will prove short-lived. A strong dollar has bearish implications fordeveloping economies and could lead to a dramatic sellof of currencies, bonds, andequities in fragile twin defcit countries like South Africa, Turkey, Argentina, Brazil, andpotentially India. Gold has a strong negative correlation to the DXY so would likelytrend down.The perils of this scenario are clear. Which explains why German chancellor AngelaMerkel and French president Emmanuel Macron are pushing new pan-European fscalstimulus. But the plans as conceived won’t be enough so long as austerity hangs like asword of Damocles over the economy’s head.Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorScenario 2: MutualizationSo what can be done instead? The EU could buy most of the national debt, fnancing thepurchase through the massive issuance of additional joint bonds. This is essentially thesafe asset proposal we suggested in the spring.The safe asset could be swapped for national sovereigns on the balance sheets of thebanks and the ECB. The latter could commit to granting exclusive eligibility to the jointbond as collateral for repos as well as its asset purchases. This would efectively nip thedoom loop in the bud, particularly since the joint budgets of the member states and theECB would serve as deep-pocketed backstops.How the fnancial markets would respond to this scenario is a blueprint of what weenvisioned. The euro will appreciate relative to the dollar because mutualizationaddresses most of the structural faws of the current monetary union without a fscalunion. Spreads would converge as yields on peripheral debt will fall at frst and marketsrecognize that all of Europe is on the hook if one country fails.In the long term, national sovereign yields across Europe would probably rise somewhatbut remain low. European equity markets would outperform their US counterparts inthe short and possibly long term. Financials in particular should beneft as yield curvessteepen. The euro will improve its status as a reserve currency. If the Fed keeps onmonetizing its defcits, the price of gold will hold up and maybe even reach new highs,demonstrating the negative correlation between it and the DXY.Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorScenario 3: MonetizationIf mutualization proves politically unacceptable and austerity becomes the defaultscenario, the only remaining option is the monetization of national and potentially EUdebt by the ECB. The ECB would purchase the bulk of the debt and then cancel most ofit.While this would indicate a nominal accounting loss for the ECB, in reality it’s really justthe permanent swap of securities for legal tender, or helicopter money by a diferentname.Debt monetization could save Europe’s ailing banking system and reduce spreadsbetween Italy and Germany. But it would do little to address more fundamentalproblems. The question underlying this policy is whether loans will eventually reach theSMEs and corporates that need them the most. These policies will do very little to helpthe real economy in the long run. Quite the contrary. It is a poorly concealed attempt toavoid the inevitable: Either Europe comes together and forms a United States of Europefscal union or abandons the euro all together.Under such an either / or scenario, the long-term implications for fnancial markets willbe much more binary. If Europe abandons the common currency, austerity will be theorder of the day. If it become a federal state with central fscal capacity, fnancialmarkets will rerate according to our mutualization scenario. But that could be yearsaway, and until it happens, yield spreads between bunds and BTPs will likely hoverPost–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising Investoraround current levels or compress slightly. That’s assuming the moral hazard argumentis abandoned, at least temporarily, and the ECB buys more peripheral debt than capitalkey rules previously allowed.Initially, monetization should be (marginally) positive for equity markets. Taking a pagefrom the Fed, the ECB will act as a lender of last resort, food the market with liquidity,and monetize whatever shortfall needs to be funded. We wouldn’t expect EU equities tooutperform their US counterparts. The Fed isn’t likely to turn of the printing pressesand both central banks will continue their historically unprecedented practice ofcreating liquidity out of thin air.Therefore, as the ultimate hard currency, gold should set new highs on the back ofsurging demand. In a worst-case scenario, people might start to question the “store ofvalue” principle, which would only strengthen the case for non-cash alternatives such asgold, certain real assets, and possibly cryptocurrencies. The long-term outcome could beugly.Wrapping UpTo be sure, fscal austerity on the order of 20% of GDP is highly unlikely. The moreprobable outcome is a blend of the three scenarios, although the weights are hard to callat this stage. What would such an outcome augur for the markets?We expect the future to be weighed more toward mutualization and monetization thanausterity and for markets to focus on the positives. Under such a blended scenario, thePost–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising Investoreuro’s small rally of late should gather a bit more steam.European sovereign debt markets should remain fairly sanguine, provided austeritymeasures are kept to a minimum. Yield spreads will likely hover near current levels andpossibly compress a bit but shouldn’t rise to or exceed the highs set earlier in the year,although national sovereign curves might steepen somewhat.Assuming economies begin to normalize in a post–COVID-19 world, European equitymarkets should continue to recover. Domestic industries and exporters, particularlyintra-euro exporters, should beneft the most given how the expected appreciation of theeuro will help overseas exporters and boost internal demand.Furthermore, European companies will “onshore” more production and manufacturingactivity from facilities in Asia and elsewhere. What this means for EU equities relative toUS ones is contingent on many external factors. But, if further integration continuesapace and Europe implements structural reforms, cuts much of the red tape in thesystem, and makes progress towards more of a fscal union, EU equities couldoutperform by a signifcant margin, especially if the US debt addiction eventually hitsrock bottom.Gold prices should hold up as well under this scenario. Why? Mainly because the majorcentral banks — primarily the Fed — will continue to monetize their defcits for a longtime to come.All in all, this blended scenario is a watered-down version of what is needed tosafeguard the euro and the EU at large. Nevertheless, it constitutes a big step forwardfrom where the old continent was only a few months ago.If you liked this post, don’t forget to subscribe to the Enterprising Investor.The views, opinions, and assumptions expressed in this paper are solely those of theauthor and do not refect the ofcial policy or views of JLP, its subsidiaries, orafliates.All posts are the opinion of the author. As such, they should not be construed asinvestment advice, nor do the opinions expressed necessarily refect the views of CFAInstitute or the author’s employer.Post–COVID-19 Europe: Three Scenarios | CFA Institute Enterprising InvestorFacebook Twitter LinkedIn E-MailYvo Timmermans, CFAYvo Timmermans, CFA, is portfolio manager at Jaguar Listed Property(JLP), a global real estate securities frm, and has over 14 years ofinvestment experience spanning a wide range of developed andemerging markets. He is currently based in Amsterdam and overseesJLP's investments in EMEA and LATAM. Timmermans graduatedfrom the University of Maastricht with a master's degree in economicsand international management and recently completed an executivedegree in global macroeconomic challenges from the London School ofEconomics. Timmermans is a CFA charterholder.Paul van den NoordPaul van den Noord is an afliate member of the Amsterdam School ofEconomics (University of Amsterdam) and the Amsterdam Centre forEuropean Studies (ACES). He spent the bulk of his career at the OECDin Paris, most recently as a Counsellor to the Chief Economist, and inthe period 2007-2010 was seconded as an Economic Adviser to theEuropean Commission in Brussels. In the years 2013-2017, van denNoord worked for a fnancial institution in London and Geneva, andnext returned to academia. He has published widely in the felds ofmonetary union and the political economy of reform, includingImage credit: ©Getty Images / NastcoTags: euro, European Central Bank, European Union, Eurozone, fscal policy,fxed income, Invesment Products and Asset Classes, Monetary PolicyShare OnAbout the Author(s)

Post–COVID-19 Europe: Three Scenarios

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Post–COVID-19 Europe: Three Scenarios

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