Something important happened this week and surprisingly few people outside Europe seem to have noticed. Markets could move substantially if Angela Merkel and Emmanuel Macron can secure EU-wide backing for their new “recovery fund”.
The key problem with the euro since its founding in 1999 has been that it was — and is — a currency without a fiscal union. The euro-area crisis of 2010 to 2012 showed that very clearly, and various backstop facilities were put in place to keep it together. We remember the European Financial Stability Facility; the European Stability Mechanism; and the central bank’s Outright Monetary Transactions and Long-Term Refinancing Operations.
Then came the coronavirus, and those backstops were no longer enough. The European Central Bank got innovative (albeit with a lag) and invented the Pandemic Emergency Purchase Programme, which was a more unrestricted form of quantitative easing than before. It felt like it was unlimited, which is what the market always craves.
But just as the PEPP QE was starting, and markets were healing, the German constitutional court started to moan about the ECB’s QE. It needed to be restricted, the court argued, just like the previous incarnations of QE.
And the euro was back in crisis mode, and we saw the usual widening of bond-yield spreads, especially in Italy. The existing backstop infrastructure was insufficient; there was a lack of political will to create more policy space; and the legal challenge from the Karlsruhe court threatened to make things worse.
Then we had a surprise press conference on Monday from Ms Merkel and Mr Macron, outlining a plan to create an additional €500bn of spending power, via EU-level borrowing to distribute money in the form of grants. If you have common bonds, is that not a fiscal union of sorts? It was radical stuff: a solution to the problem.
The upshot is that May 18 2020 could turn out to be a historic day in the evolution of the euro. So far it is just a proposal. But it is a proposal that came from the two biggest countries in the union — and by far the biggest after Brexit eliminated the UK from the group. It may be a first step to address the lack of fiscal capacity in the EU and the eurozone.
But the development did not get much press outside Europe, and markets have moved only moderately.
Perhaps it is because coronavirus has taken over everybody’s brains. Perhaps it was because the press conference was in French and German.
But investors, and the people of Europe more broadly, should really care about this. Remember the Greek default and then the restructuring of about €200bn of debt in 2012? Did it rock the market? Yes. It was the only thing that mattered for the two years prior.
On that basis, Italy’s €2.5tn of debt should matter much more. Global investors should worry if that big pile is perceived to be at risk. Just think about the implications for European and global bank stocks.
As a next step, it is important to watch what the so-called Frugal Four do. Austria, Denmark, Sweden and the Netherlands are fundamentally against the idea of mutualising debts. Sebastian Kurz, the Austrian chancellor, is spearheading an effort to come up with an alternative proposal, presumably involving loans rather than grants, and perhaps smaller amounts overall.
But this is a crisis, and we do need a big response. If the grant portion were to get cut to, say, €200bn, it would not be enough to give the market confidence, and it could actually turn out to be very costly — in the form of a bigger European recession — including for the most frugal member states themselves.
And if Germany can make a U-turn in reversing opposition to fiscal union then perhaps others can come around too. We note that the Netherlands has been relatively quiet so far, which could be a positive sign. This is the key country to watch.
The key point is, that if Ms Merkel and Mr Macron can get the entire EU-27 on board, it will move markets significantly. The euro will recover from its multiyear lows versus the US dollar, the Swiss franc and the Japanese yen. Peripheral spreads can narrow notably. And European stocks may finally attract some foreign interest, after a multiyear lull, and deliver some rare outperformance.
We track global capital flows every day and we continued to be amazed by the complete lack of interest in European equities among US and international investors. If there were to be a positive policy signal, there could be huge inflows.
And once markets really start to move, people might wake up to the broader implications.
The writer is founder and chief executive of Exante Data, a data analytics and macro research company based in New York