Closer European integration and stock prices, and why staying together helps in the FX market
European stocks are higher across the board today after the EU agreed a deal on the EUR750bn recovery fund that will lead to the European Commission undertaking borrowing on the capital markets for the first time. Below we take a look at what this deal actually means, why markets may choose to curb their enthusiasm after an initial surge higher, and why this news is universally positive for the euro
The guts of the deal
The news from the EU summit that gives the green light to the biggest joint borrowing ever agreed by the EU, has been called a “pivotal moment” for Europe. The EUR750 bn package will be split between EUR390bn of grants to be given to those hardest hit by Coronavirus, mostly to Italy and Spain, and then EUR360bn of low interest rate loans that will be available to all members of the bloc. The deal did not come easily, with Denmark, Sweden, the Netherlands and Austria demanding large rebates on their EU budget contributions in return for agreeing to the package. However, analysts are now parsing the detail of the deal to see what it could mean for European bonds, stocks and the euro.
Is the deal a disappointment?
Before we look at the impact on European assets more closely, we would point out that the scheme is smaller than what was planned in May, when EUR 500bn of grants was touted as possible. As usual with EU funds, the receipiants of the grants will need to prepare national recovery plans to reform their economies before money will be released. There will also be an EU instituted governance mechanism to allow a member state to complain if they think that a recipient of a grant is not using the money to fulfil its reform purposes. All loans that are issued through the EU Commission will need to be paid back by 2058, however, the issue of paying back the money is still very much up in the air. The EU had hoped that the summit would lead to an agreement that member states will give the proceeds of new environmental levies and digital taxes to the central coffers in Brussels, however, the leaders’ summit only produced a levy on plastic waste. The fund still has some more hoops to jump through before the grants and loans can be distributed. There needs to be an agreement to loosen EU members states’ fiscal rules as well as an expansion of the EU’s budget headroom, which means that the gap needs to widen between actual EU spending and the amount that the EU can raise from member states. This needs to be agreed by each state, which may not happen until next year. Overall, this money is not a blank cheque for EU member states to spend with abandon, all monies comes with a catch, and it won’t be distributed for some time. Below we take a look at what this deal means for European asset prices.
Bonds:
This should be good news for European bonds, especially for smaller nations and those rated below AAA status, for example Ireland and Greece; Spain and Italy are also rated well below A. Having debt issued centrally should enhance the value of bonds issued by highly indebted nations including Italy. On Tuesday, the yields on short term Italian debt fell, while longer dated debt saw a slight rise in yields. This suggests that, for now, the market thinks that the scheme will be beneficial at the short end of the curve. However, overall, the impact on the European bond market has been small, since the fund is relatively limited in size at EUR360bn, and is less than the market had expected. Interestingly, German bond yields also fell, although, as the largest economy in the Eurozone, it is unlikely to benefit from the bonds themselves. However, a Eurozone that is knitted together fiscally goes some way to protect the EU from forces that are trying to break it apart, which is undoubtedly good news for Germany. As usual, the bond market has given a cautious welcome to the EU deal, however, we do not think that bond yields, especially in the Eurozone periphery and in Italy, will shoot higher any time soon, and we could enter a calm period for European debt markets.
Equities:
Stocks have warmly welcomed the agreement among EU members, and the German Dax rose to its highest level since February. There were also large gains for the Italian FTSE MIB, the French Cac and the Spanish Ibex index, which all saw gains of more than 2% at the European open, although gains have withered as the day has progressed. While European stocks are higher, the market has calmed down as details of the deal are digested. For example, it still needs to be ratified by all member states and the money may not be ready until next year. Also, decisions about how grants will be invested, for example in green technology, have yet to be made, which may also be tempering enthusiasm for European stocks as we approach the end of the day. However, the gains in European stock markets on Tuesday have been broad based, suggesting that investors have warmly welcomed the deal; there have also been strong gains for stocks that are linked to economic growth in the region such as German car makers. However, it wasn’t all good news for European corporates banks were some of the biggest losers on Tuesday. The reason that banks shunned the rally may be due to the following: firstly, if this is the start of debt being issued centrally in Europe then it is likely to keep a lid on interest rates for the long term, low interest rates impact profitability for banks’ lending activities. Secondly, a lot of the good news has already been baked into some banking stocks. Deutsche Bank had been one of the best performers on the Dax in recent months, yet it is down 3.3% today, even though it is likely to beat earnings estimates for Q2. The risk is that low interest rates erode profitability in the future, and that there is already too much good news baked into the DB share price, hence its decline today. Overall, European banks could struggle, while we expect growth sensitive sectors like European builders, industrial firms and big ticket manufacturers to continue to do well in the short term.
The euro:
The single currency has also done well on Tuesday as closer European integration helps to secure the future of the euro. It is struggling around the $1.1480 market vs. the USD on Tuesday afternoon, but we expect it to surge past $1.15 in the short term. EUR/USD is at its highest level since October, and we may see further gains back towards the $1.1750 level, the high from September 2018. While we think that momentum is on the side of the euro for now, especially due to dollar weakness across the board, we could see some profit taking in the next day or so. Overall, we expect to see the euro follow European stocks higher, as the FX market prices in a premium for the euro, especially versus the USD and GBP, as a result of closer fiscal integration in the EU. The euro is like the anti-Brexit trade, in the FX space, staying together pays.