The Eurozone Responds to an Economic Shock | Lord Abbett
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Institutional Perspectives

Our expert looks at the eurozone’s fiscal and monetary responses to the COVID-19 virus and their potential impact on politics in the region.

Over the past week, the impact of the COVID-19 virus on Europe deepened and governments intensified their mitigation measures by severely curtailing everyday activity. This economic impact of this crisis is different from typical recessions in that this is a globally synchronized event that hits hard at services and small businesses, resulting in cataclysmic estimates of economic damage.

Europe has responded to this by throwing away the usual constraints on fiscal and monetary policy:

  • The European Central Bank (ECB) unleashed a new €750 billion euro “pandemic purchase program” and expressed its openness to deviating from its capital key – the previous rigid adherence to conduct quantitative easing (QE) in proportion to national central banks’ capital share of the ECB – if necessary.
  • The European Commission (EC) on Friday (March 20) suspended the Stability and Growth Pact, the set of rules that had put limits on fiscal spending, and is said to be considering some role for the European Stability Mechanism (ESM), Europe’s pooled emergency bailout fund, in the current crisis.
  • Lastly, European countries have responded with large credit guarantee funds and fiscal stimulus, the most notable of which (due to its traditional restraint in spending) is Germany, which will offer guarantees worth 13% of gross domestic product (GDP) and fiscal spending worth some 3-4% of GDP.

The Fiscal Response
National governments have responded with large fiscal outlays and credit guarantees. The credit guarantees are a particularly important part of resolving the current crisis as many businesses need “bridge financing” to carry them through to the time when the virus outbreak is controlled. In other recessions investment might plummet or financial entities might implode first, but in today’s case the activity hit is in the “real economy,” which is in goods and services rather than in financial entities. To summarize some of the unprecedented, colossal fiscal packages announced so far:

  • Germany: €460 billion of bank loan guarantees (13% of GDP) and €100 billion of fiscal spending (3% and potentially more).
  • France: €300 billion loan guarantees (12% of GDP) and €45 billion (1.7% of GDP) of fiscal spending.
  • Italy: €350 billion loan guarantees (17% of GDP) and €25 billion (1.25% of GDP) of fiscal spending.
  • Spain: €100 billion loan guarantees (8% of GDP) and €100 billion fiscal stimulus (8% of GDP).
  • UK: 330 billion GBP loan guarantees (15% of GDP) and fiscal measures worth around 4% of GDP. Most interestingly, the UK government has decided on a unique business grant scheme whereby the government covers 80% of employee salaries to avoid layoffs – and has underscored that there is no limit on this job retention scheme.

As mentioned above, the EC has taken the extraordinary step of suspending the eurozone’s fiscal rules and they are further contemplating the use of the ESM. The question of the ESM gets directly to the heart of a major problem of the eurozone: How much pooled risk sharing will countries tolerate and how much control can there be placed on countries’ treasuries?

The question of using the ESM is therefore also a question of conditionality on European countries. Although Germany has signaled its openness to “coronavirus bonds” – pooled-risk debt issuance – it remains to be seen what conditions will be put on participating countries. The main way the ESM would operate in this crisis, according to press reports, is through the Enhanced Conditions Credit Line (ECCL). If the ECCL is designed in such a way that all European countries qualify for it – whether they need it or not – then this will reduce the stigma of accessing it.

The Monetary Response
Using the ECCL actually paves the way to unlimited bond buying by the ECB through the Outright Monetary Transactions (OMT) program whereby the ECB purchases bonds in secondary markets. (The ESM could also begin to purchase a country’s bonds in the primary market, enhancing all of the above). OMT was originally designed to be used in the case when the bond markets’ dysfunction was challenging the continued economic stability of a particular country, a kind of unlimited war chest to push back against speculative runs against a particular European country.

In the current crisis, there is an exogenous shock hitting all countries at once. The ECB has already embarked on a temporary increase in its QE program, called the “Pandemic Purchase Program,” of €750 billion; these types of bond purchases are across all countries and are typically aimed at a common economic shock. But discussions of coordinating with the ESM and the burgeoning scope of the economic damage suggest there will be unprecedented fiscal and monetary policy coordination going forward.

The Political Response
Although it is not entirely appropriate to compare today’s crisis to the Second World War, many have done so, and the question arises, will Europe be the same afterwards? Has this crisis awakened Europe with new resolve – to reference a famous Japanese admiral’s quote1 from WWII – or will Europe succumb to a downward spiral as nationalist parties exploit fractures exposed by the coronavirus outbreak?

Large economic shocks, like the 1929 crash or the Russian revolution, are hard to handicap in real time, but I would argue that the current consensus on the political fallout from this crisis for Europe is something like the following. Nationalist parties will gain clout from a populace angered about open borders. A lack of global leadership, due to an inward-facing United States, further puts pressure on individual European countries to put their needs first rather than unite under a common European banner. Authoritarian governments, boosted by their ability to lock down their populations during the virus outbreak, receive a huge “branding dividend.”

However, this crisis also exposes a problem with nationalism: their version of personality politics and quick-fix solutions runs into a brick wall during a crisis that requires credible, science-based leadership. I would argue that consensus isn’t putting enough probability on a turn to the left in Europe.

An alternative may reside in the green movement in Europe. In 2019, Green Parties – typically political organizations geared toward social justice and environmentalism – outperformed their polls and gained many seats in the European Parliament. The Green Party is the second-largest party in Germany. Climate change, much like a viral outbreak, requires coordinated global action and technocratic guidance. To note, in the aftermath of World War II – something the current crisis is often compared to – the United Kingdom turned to nationalized healthcare and the Labour Party as they wanted greater social programs in the aftermath of the war.

And just because we may see more left-wing resurgence in the years ahead doesn’t mean we will see increasing globalization. In my view, Europe will probably still be wary of immigration in the coming years, although I believe Europe will eventually return to full usage of the Schengen system. I think there is still too much benefit from the full functioning of the Single Market.

 

1“I fear all we have done is to awaken a sleeping giant and fill him with a terrible resolve.”
-From the diary of Admiral Isoroku Yamamoto, who planned the attacks on Pearl Harbor.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Although government treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

Enhanced Conditions Credit Line (ECCL) is a credit line open to all euro area countries  whose general economic and financial situation remains sound but who do not comply with some of the eligibility criteria for accessing a Precautionary Conditioned Credit Line.. The country will be obliged to adopt corrective measures aimed at addressing such weaknesses and avoiding any future difficulties in respect of access to market financing.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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