Could fiscal integration for the euro area drive a rally in risk assets and a stronger euro over the long term? Markets could be underestimating the possibility.
Like most investors we speak with, we’re reluctant to take our eyes off our screens in case we miss the next headline on the Italian budget. The next significant piece of news will come on September 27, when Italy will release its Economic and Financial Document, offering an indication of the planned fiscal deficit. This is likely to be a key short-term market driver.
If policy-makers do surprise the consensus and embark on a path of fiscal integration, our strategists think markets could deliver significant upside surprises.
My colleagues and I at Morgan Stanley Research think the feedback loop between fiscal headlines and the market response will shape the outcome: attempts to engineer substantial fiscal expansion will likely dampen market sentiment, producing informal announcements of scaled-back fiscal plans that lift investors’ spirits… that is, until the next headline on fiscal expansion. While the ride will likely remain bumpy over the near term, the middle-ground outcome we envisage may well come as a tactical relief to markets.
However, outside of the budget for any one country, a different debate in Europe has been producing headlines recently: prospects of a budget for the euro area as a whole.
The news flow has been eye-catching. Policy-makers from core Europe have been suggesting a euro-area wide budget and common fiscal tools because, despite a relatively benign macro backdrop, euro-area growth is beginning to slow. Risks are now more skewed to the downside. And the longer the cycle runs, and the tighter financial conditions become, the greater the risk of a new crisis.
But with European Central Bank (ECB) monetary policy yet to normalize, a critical question for both policy-makers and investors is what happens when the euro area faces a fresh challenge. Will the next recession pull Europe together or cause it to fracture?
According to the consensus, the past decade has seen limited progress towards integration, and not much will be achieved over the next one. The chances that the region can develop common fiscal tools and address its structural deficiencies are low. So, when the next crisis hits, the euro area will struggle.
To us, this is too skeptical a view. We see a greater chance of fiscal integration.
The recent Franco-German agreement in principle on a euro-area budget is a significant development that we believe markets have overlooked. We think it reflects the awareness that the ECB has less room to maneuver in the face of the next downturn, implying a larger role for fiscal policy to provide shock absorbers.
In a recent report, we frame how the future of Europe could play out over a 10-year horizon. While full fiscal union isn’t our base case, the market appears to underestimate the possibility that the region could start to fix its structural faults and integrate fiscally. The road may be rocky at first, but it could ultimately lead to a more ‘federal’ fiscal policy. This in turn could start to address some of the structural issues that have dogged the euro area in the current cycle.
If European policy-makers do surprise the consensus and embark on a path of fiscal integration, our strategists think markets could deliver significant upside surprises. On the back of stronger economic growth and a sustained drop in risk premia, the region could see a major rally in risk assets, a stronger euro and a normalization of interest rates.
The biggest gap between our long-run expectations and those of the markets is in European equities where our strategy team sees value even today, before any longer-term progress. Averaging across our scenarios, European share prices could end up ~120% higher than the 10yr forward (~8.2% compounded). For USD investors, these long-run figures look even more dramatic.
We’re not suggesting that further steps towards fiscal integration, along with existing monetary tools, can prevent the next recession or abolish the cycle. But we think markets underestimate the possibility that policy-makers will respond to Europe’s vulnerabilities with more integration, not less. Despite the obvious difficulties, including political ones, this could strengthen the euro-area economy structurally over the longer term.