Europe: Coming together again?

I recently spent a few days meeting key policymakers across the government, fiscal, regulatory and monetary spectrum, in France, Germany, and Brussels (where the European Commission is based). Here are my key takeaways.

I was taken by a very different narrative on this trip compared to anything I have heard previously. Europe feels like it has been in a state of ‘perma-shock’, and, like most systems that survive under stress, it has become more, not less, resilient. The shocks that have built this newfound resilience have been the eurozone debt crisis, Brexit, Donald Trump’s US presidential victory, the global pandemic, Russia’s invasion of Ukraine and the inflation crisis, all of which have contributed to give a sense of purpose to Europe, and one in which the region appears more self-assured and better aligned on national and regional policy.

While Europe still appears to struggle to define its vision relative to China, or even the US, it seems more confident about the steps it needs to take to deal with the realities it faces closer to home. The key recurring themes from my European meetings included the following:

• Defence spending was the biggest topic, as well as the most politically sensitive.
• Fiscal frugality appears to be dead, with fiscal leniency the new buzzword.
• A renewed focus on competitiveness.
• A determination within the European Central Bank (ECB) to see things through, beyond simply fighting inflation.
• Climate adaptation remains a strategic priority.
• A sense that there are a range of potential tools that could be deployed in response to any future potential US or Chinese tariffs or sanctions.
• Likelihood that the next European parliamentary elections may produce a shift to the right.

Defence

The most striking aspect in all my conversations was the extent of the war mentality at play among policymakers. That sense was palpable, and 2024 could be the pivotal moment for Europe with the approaching US elections and Ukraine recently losing ground. There were concerns about a potential Baltic state conflict scenario, in which Russian President Vladimir Putin might test Europe’s resolve.

We are set for a major ramping up of European defence spending, with the potential for up to €100bn per annum to be raised via a common European Union (EU) fund, and new regulation being slated for the European Investment Bank (EIB) to support the financing. Some of this burden will be borne at the European level in the same manner as the previous NextGen EU pandemic recovery initiative.

The UK may become a beneficiary of this development as it is possible that the EU could find it more palatable to buy defence equipment from the UK (particularly if the Labour Party wins the next general election and forges a closer partnership with the EU in certain areas) rather than from the US for domestic political reasons. Europe appears happy to go it alone in terms of funding for Ukraine, as there is an expectation that if Donald Trump wins the US presidential election, he may seek to make a deal with Russia to end the conflict in Ukraine. This war has broken many taboos, including reliance on Russian energy, Finland and Sweden joining NATO, as well as the increase in defence spending pledged by many European nations. What is currently still up for negotiation is how to fund the group defence effort. However, from my conversations, it felt like the defence funding equivalent of former ECB President Mario Draghi’s pledge in 2012 to do “whatever it takes” on monetary and fiscal policy in relation to the sovereign debt crisis.

US

There appeared to be no undue concerns about a Trump US presidential win, or the potential for ensuing tariffs. New EU legislation now gives the European Commission authority to retaliate promptly without going via the World Trade Organisation (WTO) first. European Commission president Ursula von der Leyen is politically close to US President Biden’s current administration and highly focused on business competitiveness. Legislation is currently being developed which will seek to mitigate the impact of any potential future tariffs.

China

It was clear from some of my meetings that despite some divergence on values, there are continuing efforts to engage and cooperate with China. The European Commission is particularly focused on dealing with the issues arising from Chinese tariffs being deployed to subsidise China’s electric-vehicle (EV) sector, with work focusing on EU member states’ ability to extend tariffs over longer time frames. Overall, I found the mood on China to be non-combative, with a meaningful degree of cooperation concerning trade and renewable energy, where both regions’ goals are broadly aligned.

Trade

Economic security is deemed paramount, with a focus on protecting critical infrastructure, preparing measures to protect against any perceived weaponisation of trade, and preparations for greater digitalisation. Another clear priority is to diversify supply chains and sources. The European Commission is currently negotiating with India, Indonesia, the Philippines, Argentina, Brazil, Paraguay and Uruguay, while the net-zero energy transformation plays a central part in trade policy. Mario Draghi will be publishing his eagerly anticipated report on enhancing Europe’s competitiveness in June.

Fiscal

The European Commission’s guidelines are that its member states should aim for no more than a 60% debt/GDP ratio over the long term, but, of course, many countries have exceeded that level, even when the Covid effect is excluded. New fiscal procedures come into effect later this year, but defence will be a separate issue. The ECB is somewhat concerned about fiscal deficits, for France in particular, but it seems difficult to see anything other than a market-driven resolution over the long term.

In the event of a market-shock event, there appeared to be confidence that it could be countered via instruments such as third-party providers (TPPs). Currently, Greece, Italy, France, Spain and Belgium fall into the fiscal concern bucket. There also appeared to be little appetite either to raise taxes or to cut spending anywhere. In Germany, there was a sense that things could get tougher under a Trump presidency, with the country relying on around 600,000 migrants a year, given its challenged demographics.

Capital markets union

I witnessed a concerted effort to push for greater capital market union, and the French have put forward a Coalition of the Willing proposal with countries that are willing to see greater integration. A framework to deal with insolvency and a European equivalent of the US’s Securities and Exchange Commission (SEC) were also topics of discussion. The issue of liquidity and resolution has resurfaced with no apparent real appetite for a banking union. Further funding is required for climate transition and defence, but my sense was that this should be feasible via the EIB.

Climate transition

There has been some pushback on funding the climate transition, with some complaining at the lack of consultation with the public and the corporate sector ahead of publishing existing legislation. As the political mood shifts to the right and populism, some of the ambition and deadlines seem likely to be delayed or postponed. A decision was made not to impose tariffs on China’s solar panel imports as cheaper panels are deemed better for the energy transition plan even at the risk of making local producers less competitive.

ECB

Europe is a bank-based system with a duty to provide liquidity to banks. More collateral available for use by banks has meant increasingly more liquid conditions over the last two or three years and a greater willingness of banks to lend in this environment. There was also a sense of differences in approach between former ECB President Mario Draghi, who made more executive-led decisions, and current ECB President Christine Lagarde, who is broadly viewed as more collegiate.

The ECB is buoyed by healthier balance sheets across the corporate sector, although concerns about the deficits of some countries persist. There are still some concerns that Europe’s lack of growth may be owing to more structural factors and not primarily as a result of higher rates, so some are questioning the need to cut rates currently. However, the general mood at the ECB right now is dovish, as it focuses on banking transmission and credit.

There remain some concerns about the extent of sick leave across the EU and its impact on competitiveness as the region has one of the lowest hours-worked statistics anywhere in the world. Another current concern is the financial stability of Russia’s frozen assets and the European banks that may be implicated. There is also continuing debate about how interest from the frozen assets might be deployed to help support Ukraine and the legal implications of such a move. Meanwhile, efforts towards the full digitalisation of the euro continue apace.

Investment implications

We would expect to see an ECB that will be quick to tackle any future funding or fiscal crisis, and one which is likely to be integral in efforts to finance the greening of economies and increases in EU members’ defence budgets. This will be likely to make valuations more challenging for bonds on a real yield basis. Interesting sectoral opportunities might emerge owing to expenditure in defence and the continued support for energy independence. We would expect currency opportunities to be largely driven by fiscal attitude and central banks, so we may see some appreciation in the euro this year, but with real yields set to stay low by historical standards we are likely to see volatility persist. We would also expect a more favourable backdrop for UK growth if cooperation between the EU and UK improves markedly. This could prove positive for UK assets and for sterling.

Authors

Ella Hoxha

Head of Fixed Income