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Last week, the EU region took a giant step for a more fiscally integrated Europe with all 27 leaders of the EU member states approving the European Commission’s proposal for a joint COVID-19 crisis recovery fund. Gabriela Santos from JP Morgan notes that this recovery plan is a small step for fiscal integration but a giant leap for Europe and European assets, whose equities have underperformed the US by 174% pts in USD terms over the past ten years. 

Key quotes

“The details include a €750 billion recovery package (worth 5.4% of GDP), of which 52% will be grants and the remainder loans. There are a few transformational aspects: 1) it will be financed by the large issuance of common EU bonds, 2) the debt will be serviced by the EU budget, and 3) the funds will be allocated to countries based on need, not on contribution to the budget.”

“High-debt countries like Italy, Spain, Portugal and Greece will receive more in funds than they contribute, while high-income countries will be net contributors. Crucially, high debt countries will receive these funds financed by the European Commission’s AAA rating, instead of by their own much lower ratings. While this is exactly what the US does for its states on a regular basis, EU countries had never agreed to this level of fiscal federalism before.”

“There is now a lower risk that populations will become frustrated by the lack of benefits of the union and will vote to leave the project altogether. This lower break-up risk means that European assets need to embed less of a risk premium, allowing for higher equity valuations, lower bond spreads and a stronger currency.”

“While there has been some more optimism around European equities over the past two months, it is far from an overbought asset class. There is still a lot of ground to make up the 240 billion USD in outflows out of European equity funds over the last 30 months.”