by David Zahn, CFA, FRM, Franklin Templeton Investments
After much debate, the ink is now dry on Europe’s €750 billion coronavirus fiscal rescue package, initially proposed in May. David Zahn, our Head of European Fixed Income, says it marks a strong affirmation of European integration and support for beleaguered countries—good news for investors.
After a period of intense debate and discussion over several days, European Union (EU) leaders finally reached an agreement on a €750 billion (US$858 billion) COVID-19 rescue plan. The plan contains low-interest loans as well as €390 billion (US $446 billion) in the form of grants to be given to the hardest-hit member states.
Recipients will need to prepare national recovery and resilience plans for 2021-2023, including their efforts towards boosting growth and jobs (including any “green” initiatives) and helping to reinforce the “economic and social resilience” of EU countries.
Significantly, the EU will now become a formidable borrower in global financial markets. In 2036 net debt issuance is to end, and the EU has pledged to repay the new debt by 2058. It will need to be paid out of the EU budget, likely through some additional taxes, for example, on non-recyclable plastic waste. This will lead to a significant new supranational borrower that currently has around €50 billion outstanding, increasing to around €800 billion. The European Central Bank (ECB) will be able to purchase those bonds after issuance expanding the quantitative easing opportunity set.
The “Recovery Plan for Europe” outlines three main goals or “pillars” wherein investments will be channelled to: help support member states to recover, repair and emerge stronger from the crisis; kick-start the economy and help private investment; and learn the lessons of the crisis and address Europe’s strategic challenges.
The other major step forward in this legislation is the commitment that 30% of the Coronavirus Recovery Fund and the €1 trillion seven-year budget are earmarked for fighting climate change. This is a massive step towards the greening of the European economy and moving to a carbon-neutral goal in 2050. There will be over €500 billion in spending on greening of the economy, and we would anticipate this driving more change across the continent. This is very supportive to the for the green bond market, and we would expect more issuance and a broadening of issuance to support this focus.
Good News for Europe’s Economy—and Markets
The approval of the rescue plan is excellent news for the European economy, and it also is good news for European fixed income markets, because it will bring down the risk premium (the amount of additional return required for the political risk of Europe, which has been reduced) across Europe. From an investment standpoint, the news looks quite positive for government bonds, corporate bonds and probably other European currencies in addition to the euro.
The COVID-19 pandemic has ravaged the economy, and the approval of the plan sends a message that Europe is not as risky to invest in now as it might have been before.
Therefore, the risk premium should decline, particularly when combined with the ECB’s monetary policy support in the form of quantitative easing and ultra-low/negative interest rates, which look likely to continue for a long time. In our view, this combined response to the COVID-19 pandemic is going to be really powerful in terms of helping the European economy start to recover.
That said, these supportive actions don’t necessarily mean the European economy is going to recover quickly. It will probably take several years for a full recovery to get back to pre-COVID-19 levels, but it does mean the building blocks are now in place from the fiscal and the monetary side.
The COVID-19 crisis has had a deflationary effect, and we think even with some recovery, inflation should remain quite low within Europe this year and probably into next year. Some observers are concerned that in a world awash with liquidity from all this fiscal and monetary support, we will see an inflationary spike down the road. Certainly, that is a potential concern, but we see that as several years down the road. That concern is a reason for investors to consider some defensive assets within overall portfolio construction.
The ECB doesn’t see it being a problem in the near future, so we believe it will remain very accommodative, which would be supportive for European bond markets for the next two or three years.
Support in the Periphery
In our view, European bond markets should now be very well supported, and yields will likely be capped because if countries can borrow from the EU at a low interest rate, it means that they will not have to issue as much of their own debt. This is also quite positive from an investor point of view, particularly when looking at the peripheral markets such as Spain and Italy or places such as the Czech Republic or Romania, which has euro-denominated bonds. At the moment, we think peripheral spreads offer value.
Of course, Italian politics in particular can be volatile—and that’s always a risk to investors there. However, we are used to seeing governments turn over there. Italy and others hit hard by the pandemic should benefit from this rescue plan, which demonstrates support for individual countries suffering.
Of course, there were disagreements amongst EU members about this plan, and there will mostly likely continue to be over other matters. But overall, we think the EU has done what it needed to do in response to the crisis, and this is a huge step forward to bring countries together and further European integration.
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