Morgan Stanley
  • Thoughts on the Market
  • Jun 13, 2020

Special Episode: Europe’s Moment of Solidarity

With Reza Moghadam and Andrew Sheets

The proposed €750 billion European Recovery Fund could represent more than just a recovery from COVID-19. It may also signal a new era of political and economic unity.

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Current Episode Trancript

Andrew Sheets: Hello, and thanks for joining the special edition of Thoughts in the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley Research.

Reza Moghadam: And I am Reza Moghadam, chief economic adviser to Morgan Stanley.

Sheets: Today, we'll be talking about the proposed EU recovery fund, some of the key debates facing policymakers, and how investors are viewing the proposal. We're recording this on Friday at 2:00 p.m. in London.

Reza, just to catch listeners up to speed. Maybe you can start by covering a few high points of the 750 billion euro recovery fund that's been proposed.

Moghadam: First of all, it is  I think a both political and economically significant step. It is politically significant because it's a strong signal of solidarity in Europe. The countries with stronger fundamentals, with financial muscles such as Germany, are prepared to help countries that have been more severely impacted by Covid-19 and whose economic fundamentals are weaker. Let me give a few details. How does it work? Essentially, the EU countries enable the European Commission to issue 750 billion of long term AAA rated bonds. That is just over 5% of the EU GDP. They will then distribute this to member states. About 500 of it will go to grants, so it doesn't have to be paid back. And about 250 billion of it, goes in form of loans. The bulk of the funds-- and this is where the economic significance comes through-- the bulk of the funds will go to the regions and the sectors that have been affected adversely by Covid-19. And some of the funds will be used to invest in green and digital priorities across the EU.

Sheets: So this idea of Europe coming together,  Europe using its joint fiscal power to help weaker regions. You know, this has been something people have been talking about for a long time, about something that would really help and stabilize the European economic project. And yet here we are in 2020. It's only being proposed now. So what are the forces that have led Europe to finally go down this path where there's a more explicit ability to shift money from some of the wealthier countries towards some of the more struggling ones?

Moghadam: Europe makes progress, but in small steps. And I think the view about supporting each other has changed. There has been a significant change in thinking in northern European countries, particularly Germany. And I suppose there are two reasons behind it. There has been questions raised whether the Euro Area in particular can survive this crisis as a unit. The viability of the euro area has been questioned. And secondly, there is also self-interest here. The EU as a whole, is probably the largest trading bloc in the world. The countries in the EU trade more with each other than they do with, say, U.S. or China. So a stronger European periphery is in the interest of all European countries, particularly Germany when global demand is weak.

Sheets: Reza, also, when we've talked about this, you know, you've mentioned a number of times that been very impressed with the structure of the proposal. And I was just hoping you could elaborate a little bit more on that. You know, especially in light of what have been some of the concerns raised by some of the other countries in Europe, countries like Finland or Netherlands or Austria, which have historically been opposed to efforts like this to create more fiscal integration.

Moghadam: What I think is clever and very deftly drafted by the EU Commission in terms of the proposal is that they have tried to address different the concerns of different constituents. For example, green issues and digital investment are very big issues of concern to the electorate of some of the countries you mentioned. And so there is a large amount of spending that is going to be done on that across the Eurozone. Similarly, the central and Eastern European countries are concerned that they have lower levels of GDP, but they will have to, in some cases, contribute to the budget disproportionately.

Moghadam: So what the commission has done here is that it has increased the so-called cohesion funds that go to the countries in Central and Eastern Europe. So all these make me confident that there is something for everyone in this. And therefore, the negotiations will be difficult, adjustments will be made, but it is likely to go through. 

Sheets: And Reza, how likely do you think it is that a deal can be reached by July? And, you know, assuming progress, how long do you think it would be until the fund would actually be implemented?

Moghadam: I think July is a key date. Why? Because Germany takes up the presidency of the EU at the beginning of July. It is also Mrs Merkel's final presidency in the EU. So there is a lot of symbolism attached to that. But also already there is a meeting scheduled specifically on this issue among all the EU 27 leaders on July 6th and 7th. Now, the proposals will only be implemented next year, and the disbursements go over 2-3 years. So I think that is a very good chance that it will be done in July. If not, I think September will be the critical time.

Moghadam: Let me ask you about the views of investors and market participants. I think we hear a lot that while the official sector is very much excited about this idea and they are very optimistic about its prospects, the markets are not as excited. And so how do you see that?

Sheets: Yeah, I think that's right. I think there's been a lot of investor skepticism. And you know, as you're well aware, you know, that skepticism is based on the recent history of Europe, that there have been a lot of false hopes in this region but a lot less progress. And I think that's lent you know, the euro to be a longstanding underperforming currency, the stock market to be a longstanding underperforming stock market. And it's also really important, I think, to grasp just how severe some of these structural issues are. I mean, think about it. Every you know, almost every year there's quite a bit of federal transfer on a net basis from certain states like California to certain states like Kentucky. And yet, you know, within Europe, that ability to move money between stronger and weaker regions has obviously been much more constrained by a number of factors. And it's led to a lot of these vulnerabilities. Vulnerabilities that mean that government debt in Europe has been far riskier in the eyes of the market than government debt in the United Kingdom or Japan or the US.

Moghadam: One aspect which is very novel about this proposal is the issuance of a very large stock of safe assets, euro safe assets. How do the market participants see this?

Sheets: So I see it perceived as an underappreciated element. And at least in a lot of my conversations with investors, certainly a lot of U.S. investors, I think there's an under appreciation for how big an economy the European Union is. It's a bigger economy in dollar terms than the United States. And yet it doesn't have a single common bond. It doesn't have a single common debt instrument like a U.S. Treasury. And I think the U.S. has benefited greatly from the Treasury market. The fact that it's given global investors a single safe, very liquid, very easy to understand, instrument to invest in, whereas, you know, investors looking at Europe, they could buy government bonds in Germany, government bonds in Italy-- a host of other countries. And so, you know, in creating this single jointly backed bond, as you mentioned, I think it's a really big deal. And, you know, we think it would be very popular. We think a lot of investors will want to own it because of all those characteristics. And the introduction of it we think we'll reduce some of the scarcity premium that's been applied to, at the moment, to German bonds, which is a reason why we think this will lead German bond yields to be somewhat higher as a result.

Moghadam: Maybe one final issue to ask you about, Andrew. As you know, European policymakers are very much focused on green finance, and part of this package will surely be focused on green and digital finance in the EU. What kind of reception do you see among global investors in that area?

Sheets: I think there's a lot of interest in it. I think we've seen significant inflows into so-called ESG strategies, those that have an environmental, social or governance focus. I think environmental issues have probably been at the top of those three factors in terms of what investors have focused on. And, you know, this is one of the big reasons why our equity analysts structurally have become so much more positive on the utility sector in Europe. It's really transitioning from kind of an old economy style sector to one that's very focused on green and renewable energy.

Sheets: But, Reza, I think there's actually another part of this story that also some very interesting kind of historical consequences. You know, I think, there's this kind of question of is this a Hamiltonian moment, you know, referring to America's first treasury secretary, Alexander Hamilton, and his desire to really roll up a lot of the old state debts into a new federal debt. And there were a lot of reasons for him wanting to do that. But one of which was that, if the states are under less financial strain, there's maybe less pressure on those states, or less incentive for those states, to go out and do kind of their own tax policy competing with federal tax policy. And that makes it harder to set that federal policy. So, you know, to the extent that maybe one of the bargaining chips in this is that in exchange for taking on more joint issuance, some of the countries have a better chance of establishing a really European-wide environmental taxation policy, environmental policy. That seems actually very much in line with what, kind of, Alexander Hamilton was thinking about, you know, going back several hundred years.

Moghadam: That's a very important issue you point out, because there is a huge incentive on the side of the EU, and the commission in particular, to put in place some form of common taxation or supplement some form of already existing taxation in order to have a revenue stream to pay at least for the interest cost of this initiative.

Sheets: That's very interesting.

 

Reza, great to have you back on the podcast.

Moghadam: Great talking to you, Andrew.

Sheets: Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people find the show.