Curmi & Partners

Europe's Turn to Shine

By Matthias Busuttil 

As several European countries were on a weak economic footing at the start of the year, the hit from the virus was broadly expected to result in a deeper economic downturn in Europe compared to other developed economies. The severe rate of contagion across several member states resulted in lockdown measures being more widely adopted across Europe by mid-March while other developed economies, including US and UK, imposed restrictive measures on a large-scale later on.

The finalised Q1 GDP data confirmed these expectations with Europe contracting by 3.6% on a quarter-on-quarter basis while the US contracted by 1.3% during the same period. Economic projections for the full year show a similar divergence favouring the US with Europe expected to contract by around 8% and the US by around 5%.

The divergence in economic expectations is mainly explained by the higher productive capacity and improved economic fundamentals in the US going into the crisis, the stronger and more coordinated policy response as well as the expectations of a shorter period of lockdown restrictions across most states.

However, recent developments in three key areas, namely: economic activity, virus control and policy response, give strong indications that the balance may start tilting in favour of a steadier recovery in Europe.

Looking at more frequent activity indicators, which serve as a good handle on how fast or slow an economy is growing (or contracting), show that the pick-up in activity has been remarkable across the two economies in May and June. However, the rebound was more pronounced in Europe given the deeper slump seen in March and April. Retail sales and industrial production saw sharp increases in May as several businesses resumed operations with the lifting of containment measures across the two regions. Purchasing Managers’ Indices (PMI) show flash estimates of the composite index in the Euro Area increasing to 48.5 in June from the low of 13.6 in April, while the US composite PMI reached 47.9 in June from the low of 27.0 in April.

The reopening of economies in Europe has so far been achieved with infection rates remaining at relatively low levels. Moreover, workforce retention has been stronger in Europe, primarily due to stricter employment conditions and government workers schemes, thus providing a stronger productive capacity to support the recovery. These encouraging signals for the region show some degree of sustainability in the rollback of containment measures and the rebound in activity. The experience in the US is strikingly different.

The US saw a considerable rise in new cases since mid-June requiring a number of states to reimpose lockdown restrictions. Even though several states have enhanced their testing capabilities, the surge in cases seems to be driven by a faster rate of contagion given the increase in positive test rates. The weak infrastructure and resources required to safely relax containment measures poses significant headwinds for the economic recovery given the high risk of another period of large-scale lockdown restrictions being introduced across the US. Moreover, the fallout in labour markets is expected to have more long-lasting effects which increases the risk of hysteresis in the US recovery.

The policy response in the US has certainly been swifter and larger in size with the onset of the crisis. Congress had quickly agreed on a stimulus package equivalent to circa 13% of GDP while the fiscal reaction in Europe was more modest across member states averaging at around 4% of GDP. On the monetary front, the Federal Reserve Bank (Fed) cut rates by 150 bps and introduced a suite of measures and quantitative easing (QE) programmes to ease financing conditions. The ECB held rates steady at sub-zero levels and likewise introduced additional measures to support shorting term funding as well as QE programmes.

However, by the end of May it became apparent that the ECB had to step up its policy response to maintain low borrowing costs and easy financing conditions. In June, the ECB announced a substantial increase in its QE programme which will result in a larger flow of funds into financial markets, particularly government bonds and investment-grade corporate bonds.

Moreover, while the fiscal response remains fragmented in Europe, the European Commission has tabled a proposal for a common recovery fund that could potentially unleash substantial financial assistance in the form of grants and loans to sovereign states to combat the adverse economic impact of the virus.

The higher degree of risk sharing and assistance to the severely hit nations that the combination of these policy measures may provide, could put Europe in a strong position to see a faster and steadier economic recovery. However, much will depend on whether EU leaders agree to the new budget and recovery fund proposals.

The more attractive mix of improving growth outlook and accommodative policy in Europe may bode well for European financial markets. The increase in the ECB’s purchase programmes relative to the size of the European government bond and corporate bond markets is expected to provide a greater direct effect on bond yields which will continue to support bond prices. Moreover, positive cyclical developments and supportive financing conditions are expected to sustain the compression in market risk premia and uplift valuations in risky assets.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.