Allison Nathan, Editor at Goldman Sachs and Co. LLC :
“Europe’s forceful pandemic response, including an unprecedented program of fiscal risk sharing, combined with a new ruling coalition in Germany that’s likely to break from the fiscal conservatism of the Merkel era, looks set to put the Euro area on a path towards increased integration, higher growth, and better investor returns. Near term, the region’s relatively high vaccination rates, large scope for catch-up growth and back-loaded fiscal stimulus reinforce the case for Euro area outperformance ahead. But the region is also particularly exposed to rising risks from a global slowdown and energy shortages, as well as the potential for the Next Generation EU Fund (NGEU) – and further economic and political integration prospects more broadly – to fall short of expectations. Whether the current moment will go down in the history books as a seized – or (another) missed – opportunity for the Euro area is Top of Mind.
We first ask whether recent progress on the fiscal front truly marks a turning point for fiscal policy in the region. Jari Stehn, GS Chief European Economist, believes the answer is yes. In his view, EU countries’ strong fiscal response to the pandemic, aided by the EU’s suspension of the Stability and Growth Pact (SGP) fiscal rules that limit member-states’ deficit and debt levels, marked an important shift in the willingness to employ countercyclical fiscal policy within the region. And, he says, the historic €800bn NGEU that, through the EU Recovery Fund, provides large-scale grants to weaker economies and long-term loans backed by the issuance of common debt, represented not only a real turning point in the crisis, but also a big step forward in the evolution of the EU – after years of fighting over fiscal burden sharing, the EU is now set to become the largest supranational debt issuer in the world.
Although the Recovery Fund and other recent fiscal measures are temporary, Stehn expects greater flexibility around institutional rules going forward and believes some aspects of the Fund could become permanent, marking a more lasting shift in intergovernmental fiscal support. All told, Filippo Taddei, GS senior European economist, sees the NGEU as an opportunity not only for sustained higher growth in the region, but also for meaningful structural change, given its investment-focused structure targeted at supporting the region’s green and digital transitions.
According to Stehn and Sören Radde, GS senior European economist, the outcome of the German election – while still unresolved – will further cement the shift towards increased fiscal flexibility in the region no matter which of the two most probable coalitions – a “Traffic Light” coalition between Olaf Scholz’s SPD, FDP and Greens, or a “Jamaica” coalition between the CDU/CSU, FDP and Greens – ultimately prevails.
But what will this shift in the EU’s longer-term fiscal mindset mean for near-term growth? Stehn cautions that the rising risks of a China/global slowdown and energy shortages centered in Europe are likely to weigh on growth in the near term, and we have recently lowered growth forecasts for the region, with 2021 growth now expected to be 4.9% yoy. Despite these challenges, he remains constructive on the region’s growth outlook relative to other major economies next year in large part owing to the back-loaded fiscal stimulus provided by the Recovery Fund, as well as the still-large GDP shortfalls, high vaccination rates and the likely easing of supply chain bottlenecks that have held back Euro area industrial production. And he’s not too worried about the prospect of sustained inflationary pressures despite the current surge, because he doesn’t see much evidence that current price spikes are becoming entrenched in inflation expectations or wages.
With these views in mind, George Cole, GS senior European rates strategist, expects higher European rates ahead. And Sharon Bell, GS senior European equity strategist, makes the case that these macro factors, as well as other important shifts in the composition and ownership of European and other equity markets, leaves European equities more attractive relative to other markets than in the past.
But Otmar Issing, former chief economist and member of the executive board of the ECB, is generally more concerned about the recent shift towards fiscal risk sharing. He argues that EU debt issuance wasn’t legal under the framework of the Maastricht Treaty, and, without a fiscal authority at the EU level that can only be accomplished via a referendum-induced treaty change, fiscal policies must remain in the hands of those who are responsible to voters: national governments. In addition to these institutional concerns, Issing is less convinced that European leaders won’t repeat the mistakes of the past by channeling funds towards consumption rather than investment – even in his own country of Germany. So he’s worried about the region’s longer-term growth prospects. And he also believes that the fight against climate change, demographic shifts, and the retreat of globalization mean that the world is on the cusp of a regime shift that points towards a permanently higher level of inflation.
Jeff Currie, GS Global Head of Commodities Research, shares these concerns about inflation – and ultimately growth – given the current energy shortages in Europe and China. He argues that as long as policymakers continue to pursue policies that support energy demand (like the expansionary fiscal policies we’ve been discussing) but constrain energy supply (via green initiatives), we’re in store for higher energy and commodity prices, more inflation, and potential disruptions to economic activity (since you can’t consume what you don’t have.)
Amid all of these shifts, the larger question remains whether the cooperation between EU members that resulted in a decisive response to the pandemic can persist beyond the crisis, and push the EU towards a stronger and more effective union. Romano Prodi, former prime minister of Italy and president of the European Commission, believes the EU is “absolutely past the point of existential danger”, and sees the potential for greater internal cooperation to tackle external threats, although he sees the requirement of unanimity around big EU decisions leading to only very slow – and ultimately incomplete – integration ahead. But Timothy Garton Ash, professor of European Studies at the University of Oxford, cautions that “Europe has seldom missed an opportunity to miss an opportunity over the last decade.” And he’s closely watching next year’s French presidential election and potential political shifts in Italy, as he doesn’t agree with Prodi that peak populism is behind us.”
What’s inside the full edition of this Goldman Sachs Top of Mind report: