The COVID-19 crisis spurs cohesion, but fresh challenges await as summarised by Konstantin Veit, Portfolio Manager at PIMCO in their latest analysis, the European Secular Outlook.
A summary of the analysis is as follows:
- The economic shock of COVID-19 and mounting concerns over climate change have fostered improved coordination among European policymakers. We believe this has reduced left tail risks and set the stage for greater stability over the secular horizon.
- Yet like the rest of the world, Europe will likely be tested by a radically different macroeconomic environment. As discussed in our recent Secular Outlook, the pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead appears to be more uncertain and uneven growth and an inflation environment with plenty of pitfalls for policymakers.
- Fortunately, Europe seems better prepared than in the past. The European Central Bank (ECB) has strengthened its role as lender of last resort for the euro area sovereign complex, and the € 800 billion Next Generation EU recovery fund (NGEU) has broken the taboo of funding government transfers via common issuance of bonds. The NGEU intends to steer public and private investment toward areas of the economy expected to generate higher real incomes in the future, namely the green and digital sectors. And while NEGU-issued bonds don’t constitute eurobonds in a strict sense, we believe they are an important step in the direction of more fiscal cohesion.
- Overall, we expect evolution instead of revolution in Europe. For instance, the prospect for amending the Treaty on the Functioning of the European Union continues to look remote, and political and moral hazard considerations continue to warrant a significant risk premium.
- Importantly, though, in economic downturns, Europe appears likely to embrace a more calibrated policy response than it did in 2008 and 2011 – when officials acted less forcefully and with less coordination in the aftermath of the global financial crisis. At a minimum, improved coordination should open up the prospect of a less crisis-prone, more stable euro area over the secular horizon. Indeed, in effect, the COVID shock constituted a massive stress test for the cohesion of the euro area. The policy response has been considerably more convincing than in previous episodes, which bodes well for risk assets.
- Will additional spending ignite more inflation? Uncertainty is higher given the pandemic shock and the many transformations that will play out over the secular horizon. Yet Europe went into the pandemic with inflation well below the ECB’s price-stability target for an extended period of time. It has also provided less crisis policy support than the U.S., for example, and fiscal policy is likely to continue to be more active in the U.S. and the U.K. than in the euro area. Thus, it remains less likely to us that, over the medium to longer term, Europe emerges from the pandemic with a high inflation problem.
- While starting valuations offer limited room for spread compression, and risks to the macroeconomic outlook remain elevated, a less crisis-prone euro area bodes well for risk assets more broadly.
- We remain constructive on peripheral spreads, Italy in particular, while focused on obtaining appropriate compensation for political uncertainty.
- Given the euro area’s unique institutional structure and differing macroeconomic conditions, we believe yields in the region will remain relatively better anchored compared to global peers, and we are fairly agnostic regarding overall duration exposure.
- Finally, we continue to favour European curve-steepener positions, as we don’t expect the ECB to be able to lift policy rates any time soon, while divergent monetary policy could make the euro an interesting funding currency over the medium term.