Europe marches two steps forward ... for now
We have been longtime realists regarding the future of Europe. As agonizing European integration efforts consistently foundered for decades—and yet still surprisingly inched forward primarily during periods of intense pressure and crisis—we discovered a plausible way to describe what we kept witnessing: it’s the two-steps-forward, one-step-back paradigm. Well, we seem now to have recently landed back in that two-steps-forward happy place again.
For years, the idealistic dreams of the European Union’s (EU) founders (i.e., France’s Jean Monett, Germany’s Konrad Adenauer and others) to unify Europe ran head first into reality: Europe was unified to some degree along economic and monetary grounds but could not unify itself along political or fiscal lines. In many ways, Europe today is more nationalist and fractured than ever before. And yet, the vision of a unified Europe keeps getting resurrected, as it did earlier this week. With the agreement reached Tuesday morning, Europe has taken two very big steps in the right direction. But it still desperately needs further integration to remain relevant on the global stage.
And that’s where we seem to be headed. As you’ve undoubtedly heard by now, the 27-member union has agreed, in principal, to an emergency recovery fund to counter the effects of Covid-19, and most important, to an institutional breakthrough—even if via baby steps—to collectively raise debt for and raise taxes on its member states. A third of the investments are earmarked for climate action initiatives supporting the European Green Deal, which may greatly assist Europe in reaching its goal of becoming the first climate neutral continent by 2050. The final agreement marked several firsts for Europe. It’s the first time Europeans have agreed to make direct transfer payments to member states. It’s the first time the union has collectively agreed to raise debts. And it’s the first time the continent has agreed to invoke its collective power to raise taxes.
Without the specter of Brexit, this agreement would never have happened. With the U.K. now sidelined and Germany alone left to represent a more laisse-faire, free-market and prudent fiscal approach, Chancellor Angela Merkel sensed change was in the air. The balance of power has shifted inexorably to France, the EU’s second most populous country and largest by land mass. Under Emmanuel Macron, France wants to reinvigorate its vision of Europe. And with its powerful military and nuclear umbrella, only France now can protect its longtime neighbor and nemesis Germany. While this seems to have been another crisis-driven event, the Franco/German alliance likely will ensure future cooperation.
The near-term implications
First, with the Fed continuing to crank up the printing presses, Asia following a decidedly less aggressive policy response and European emergency fiscal stimulus and far-reaching institutional changes in the offing, the case for U.S. dollar weakness is further strengthened. Financial repression is in full force, and a further deterioration in the U.S. current account significantly raises the risk of U.S. dollar depreciation. The euro represents close to 60% of the dollar’s trade-weighted status. Consequently, a marginally weaker dollar basically means three things: that risk assets are back in play with global liquidity enhanced, that many emerging-market (EM) economies will benefit and that long-suffering U.S.-based investors should once again profit from investing overseas. We would argue that global investors re-evaluate and increase their exposure to non-U.S. equities, in particular to the EM, as well as materials and gold stocks as an inflation hedge.
Second, the events of the past week also mean that investors with a longer time horizon should take a closer look at increasing their investments to Europe. The last time our unique top-down country allocation approach favored Europe was in 2015, and it is now starting to flag an inflection point from our current underweight stance. While an overly strong euro would be problematic for the export-focused parts of the European economy, the rest of the region should benefit. The continent has fairly successfully navigated the Covid crisis thus far and will benefit relative to the U.S. from lower, more reasonable energy prices, which are also priced in dollars. We fully expect that the events of this past week to lead to greater domestic demand, higher relative growth rates and more investment flows into the continent.
This is not to say that we’re out of the woods just yet. As always with Europe, there is the risk that it takes a step backward. Every member state’s legislature must ratify the agreement. This will take time. We will need to closely watch what happens in Denmark and the Netherlands, for example. As the bulk of the transfer aid goes to economic laggards such Italy, Spain and France, the rest of the union, especially the “frugal four” (Austria, Denmark, Netherlands and Sweden), may further balk at how the funds are spent. And with over a third of the money flowing into green investments, the danger of a misallocation of capital is heightened. Finally, the vexing issue of Brexit still hangs over the region until at least year-end. But for the foreseeable future, greater Europe’s ability to borrow and raise funds is both revolutionary and evolutionary. So, for now, let’s celebrate this return to moving forward … one step at a time.