Looking to Europe

Re-opening

In March the World Health Organisation marked Europe as the epicentre of the COVID-19 outbreak, with several of the continents’ larger countries reporting in excess of 100,000 cases.

In recent days, several European governments have indicated the economic and social restrictions imposed to prevent the spread of COVID-19 appear to have been successful. As result, some of these measures will be lifted in a phased approach.

Denmark will begin opening schools from the 15^th of April and allow some non-essential businesses to resume operations, while keeping bans on large gatherings in place. Likewise, the governments of Austria, the Czech Republic, Norway and some German states have announced plans to implement similar measures.

Encouragingly, even in the worst affected countries governments have detailed their plans to ease some of the most restrictive measures seen in the West. In Italy, the first European country to go into lockdown, the government are exploring approaches to allow a modicum of normality to return. According to governmental sources, companies and shops could recommence trading over the next weeks, with offices reopening at the beginning of May.

The incremental nature of the actions reflects the following:

 

1. governments are beginning to feel cautiously confident about the impact their policies have had on the spread of the virus. Recent data indicates that the trajectory of the virus’ spread has begun to change in some of the countries mentioned.
2. with the transmission of COVID-19 beginning to slow, governments are determined to retain control of the transmission and this is evidenced by gradual.

 

While national developments have been tentatively encouraging, at the supra-national level splits are emerging between the Member States of the European Union, with European finance ministers unable to agree a framework for a €500 billion, EU-wide stimulus package.

With the global economy experiencing an unprecedented twin shock to supply and demand there is a strong need for coordination across EU nation states. Unfortunately, some splits have emerged.

Reports of acrimony between relatively more prosperous northern member states and crisis stricken southern member states during a time of economic disruption, are reminiscent of the sovereign debt crisis a decade ago.

Now, as then, the antagonism relates to a desire to attach economic and fiscal reform preconditions to any financial aid released from the European Stability Mechanism.  insulate the economies of those member states most negatively affected by COVID-19, such as Italy and Spain.

In addition, clear divisions are evident regarding the prospect of members pooling together to issue joint debt. This would allow member states with higher debt to GDP ratios to borrow without enlarging their already high debt levels. Italy’s Debt to GDP ratio is expected to rise to 167% from 130% because of measures implemented by the Italian government at national level. This is a significant increase and could lead to an unsustainable rise in the cost of borrowing at precisely the juncture when fiscal support is required, undermining the ability of governments to alleviate the economic pressures associated with COVID-19.

 

Market Reaction

The reaction of markets to the news about disagreement was unsurprisingly for yields to move higher. The graph below details how the rolling daily percentage change in the 10-year government bond yields for both Spain and Italy. Rising yields indicates investor unease about heightened credit default risk at a time when economic growth is under threat.

Graph: Rolling Daily % Change in Spanish and Italian 10 Year Yields.

Source: Bloomberg, data as of 08/04/2020

 

Next Steps

The failure of ministers to reach an agreement on Wednesday is disappointing. It reflects the difficulty in coordinating the action of 27 institutionally equal but economically divergent economies. However, there is room for hope.

Firstly, another teleconference has been scheduled for this week, leaving open the opportunity for swift resolution if some comprises can made. Germany and France, the largest EU economies and most influential member states, have vowed to increase diplomatic efforts to ensure the package passes.

Secondly, the €750 billion bond-buying programme already launched by the European Central Bank has been designed to direct funds to those Euro area governments most in need of assistance and this support is likely increase if required.

Finally, the experience from the European sovereign debt crisis displays the capacity the European Union has for acting quickly when dictated by circumstance. The economic shock imposed by COVID-19 is one which is common to frugal and spendthrift EU states alike.  However, it could offer an opportunity to strengthen the resilience of European financial markets and prevent the reoccurrence of fiscal crises if EU leaders act with flexibility.

 

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. 

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