03 Aug 2021
In the last economic cycle Europe was a laggard. A major reason for the region’s economic and market underperformance was the years of fiscal austerity that followed the global financial crisis and the eurozone sovereign debt crisis. The sovereign debt crisis also revealed that European monetary union would be unsustainable without fiscal union.
The pandemic has proved to be the catalyst needed to fix these flaws, with the agreement of the European Commission’s EUR 2 trillion recovery fund. Not only does the recovery fund give the European Commission authority to raise debt and distribute money around the region, enhancing the European Union’s (EU’s) institutional architecture, it should also have a positive impact on European growth.
There are four reasons why investors should not underestimate the impact the fund will have on regional economic activity:
There are risks to how such ambitious plans are implemented, mainly related to possible delays to spending or the partial use of allocated funds. However, if well implemented, the EU recovery fund could ultimately prove to be a catalyst for a resurgence in investor appetite for European assets.
EU authorities love acronyms. Let’s start by clarifying the alphabet soup that makes up the recovery fund’s EUR 2 trillion fiscal package. More than half the fund, EUR 1.2 trillion, is made up of the 2021-2027 Multiannual Financial Framework (MFF), while the remaining EUR 800 billion comes from the Next Generation EU (NGEU) fund.
The NGEU fund is dedicated to promoting a green, digital and sustainable post-pandemic recovery, with the majority of funding coming from the Recovery and Resilience Facility (RRF), which is then roughly split between direct grants (that recipient governments do not need to repay) and loans (Exhibit 1).
Exhibit 1: Scheme of the EU recovery fund and its main components
The ability to provide grants – a key innovation of the NGEU plan – will help highly indebted countries to promote a strong and sustainable recovery without adding to the pressure on their public finances. Countries that gain European Commission approval for their National Relaunch and Recovery Plans, which have already been submitted, will be eligible to receive, probably by July, a first tranche of payments worth 13% of their total allocation. This will allow governments to starting making investments immediately.
Exhibit 2 compares the RRF with the infrastructure programme that President Biden intends to implement in the US, in terms of weight of GDP. We can see that Biden’s infrastructure plans are comparable to the EU’s programme, although we know that the Biden administration has broader ambitions and there is uncertainty around the final size of the spending programme.
Exhibit 2: US infrastructure proposals vs. EU recovery fund
% of 2019 GDP
It is also not yet clear if all European Union countries will request the entire amount of loans that they are entitled to. Nevertheless, over the next three years, the entire RRF funding – which is essentially the EU’s infrastructure programme – is comparable to, if not greater than, what is on the table in the US.
The distribution of NGEU funds to southern Europe will be particularly sizable. Italy and Spain together will receive roughly half of the total available funds. Exhibit 3 shows that for countries in the south of the region – Italy, Spain, Greece and Portugal – grants are large when compared to the size of their economies. The intention is to favour those countries that suffered the most in the pandemic, and that have limited internal resources to support their economies due to already high levels of debt.
The two largest EU economies – Germany and France – have access to relatively modest funding, but our expectation is that these economies will be the key beneficiaries of the post-pandemic global upturn.
There are always valid questions as to whether these resources will actually be used to boost economic growth and whether governments will allocate the funds effectively. The NGEU fund is designed to minimise this risk, since payments can be suspended if key milestones and targets are not met through the course of the programme.
Exhibit 3: EU recovery fund grants to selected EU countries
EUR billions, labels are % of 1Q 2021 annualised nominal GDP
As a base case, the Italian authorities forecast that in 2026, real GDP could be 2.7% higher than without the NGEU fund, and 3.6% higher in the most favorable scenario (Exhibit 4).
The Spanish government believes the funds will boost growth by 2% per annum in the coming four years. At the eurozone level we have raised our forecast for growth in the coming decade from 0.9% to 1.1%, meaning that at the end of 2026, the level of GDP in the eurozone could be 1.5% higher compared to a base case without NGEU investments.
Exhibit 4: Estimated impact of Italian Recovery and Resilience Plan on Italian GDP
% of nominal GDP
There is another important aspect of the NGEU fund that may serve to boost growth over the medium-term, especially in Italy and Spain. This is the structural reform that is required in exchange for the disbursement of funds. The failure to reform public administration, justice and tax systems, as well as labour markets and retirement laws, has long been blamed for the lack of competitiveness and dynamism in the region.
In Italy, the focus of reforms is on four key areas: 1) the simplification of the public procurement framework to reduce the time it takes for public works to be completed; 2) reform of the civil justice system to reduce the length of time needed to enforce contracts; 3) efforts to reduce tax evasion; and 4) efforts to effectively raise the pension age. The European Commission’s scrutiny of Italy’s reforms should be particularly strict. In this respect, it is encouraging to see that Italy’s ruling coalition under prime minister Mario Draghi has reached preliminary agreement on crucial justice system reforms.
Spain, meanwhile, has announced a package of 20 reforms that will include plans to reduce temporary workers in the Spanish labour market, the implementation of social and inclusive policies in Spanish public services, and the strengthening of the pension system.
The need for structural reforms, and the political obstacles preventing them, were very clear in the years during and after the sovereign debt crisis. The difference now is that the funds on offer in exchange for reforms are so large. In effect, the carrot has finally become larger than the stick.
Two strategic upgrades will account for the majority of NGEU fund spending, with 37% of the money to be spent fighting climate change and 20% on digital transformation. Seven flagship programmes have been identified:
Measures to boost female and youth employment will also be central to many of the recovery plans. If implemented, they have the potential to reduce the economic and social gap between the north and the south of Europe – a structural issue that has deteriorated further during the pandemic. Exhibit 5 shows the breakdown of investments for the four largest European countries in terms of green and digital initiatives.
Exhibit 5: Investment in green and digital projects of the major eurozone countries
EUR billions
The NGEU represents a multi-year growth stimulus for the European Union that could be comparable to President Biden’s infrastructure plans in the US. The impact on growth could be material and eurozone GDP at the end of 2026 could be 1.5% higher, or more if structural reforms also serve to boost productivity in the long run.
Italy is the key beneficiary, so how Italy fares will be crucial. The Italian prime minister Mario Draghi – a seasoned policymaker – has, in our view, the credibility to put the plan on a solid path, although we acknowledge risks beyond the next elections in 2023.
Funding for the recovery project is at least partly coming from the issuance of bonds by the European Commission, which over time is expected to reach a total amount of EUR 800 billion. Three tranches have already been issued, receiving stellar demand from investors. These EU securities and green instruments will extend the universe of AAA rated supranational fixed income instruments, while also offering a yield that is higher than the German benchmark.
By boosting the regional growth outlook, and by reducing the risk of another sovereign debt crisis, the recovery fund could encourage global investors to take another look at European stocks, which have been out of favour in recent years (Exhibit 6). The recovery fund may also serve up particular opportunities for companies that are key beneficiaries of the EU’s spending objectives, such as renewable energy providers, electric vehicle producers, systems facilitators and firms at the forefront of digital transformation technologies.
Exhibit 6: Cumulative European equity mutual fund and ETF flows since 2016
EUR billions
The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions.
For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programs are marketing communications and are not in scope for any MiFID II / MiFIR requirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programs, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research. This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. To the extent permitted by applicable law, we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies. Personal data will be collected, stored and processed by J.P. Morgan Asset Management in accordance with our privacy policies at https://am.jpmorgan.com/global/privacy. This communication is issued by the following entities: In the United States, by J.P. Morgan Investment Management Inc. or J.P. Morgan Alternative Asset Management, Inc., both regulated by the Securities and Exchange Commission; in Latin America, for intended recipients’ use only, by local J.P. Morgan entities, as the case may be.; in Canada, for institutional clients’ use only, by JPMorgan Asset Management (Canada) Inc., which is a registered Portfolio Manager and Exempt Market Dealer in all Canadian provinces and territories except the Yukon and is also registered as an Investment Fund Manager in British Columbia, Ontario, Quebec and Newfoundland and Labrador. In the United Kingdom, by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions, by JPMorgan Asset Management (Europe) S.à r.l. In Asia Pacific (“APAC”), by the following issuing entities and in the respective jurisdictions in which they are primarily regulated: JPMorgan Asset Management (Asia Pacific) Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, each of which is regulated by the Securities and Futures Commission of Hong Kong; JPMorgan Asset Management (Singapore) Limited (Co. Reg. No. 197601586K), this advertisement or publication has not been reviewed by the Monetary Authority of Singapore; JPMorgan Asset Management (Taiwan) Limited; JPMorgan Asset Management (Japan) Limited, which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Australia, to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Commonwealth), by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919). For all other markets in APAC, to intended recipients only. For U.S. only: If you are a person with a disability and need additional support in viewing the material, please call us at 1-800-343-1113 for assistance. Copyright 2021 JPMorgan Chase & Co. All rights reserved.