Europe has taken a bold step toward collective fiscal policy paving the way to a deeper and more integrated capital market, and a union defined by the strength of its collective balance sheet rather than by its weakest economic link. Investors gave a cautious welcome to Europe’s new initiative (the European Next Generation Fund), as demonstrated by the rally in the euro. However, it is the outlook for assets over the months and years to come that many are now scrutinising. 
History reminds us that the implications of economic policies seldom move in a straight line, and this is especially true for the eurozone, where the interplay of the 19 different nations in the bloc is an ever-present source of uncertainty. We are more enthusiastic about the outlook for eurozone assets than at any time since former European Central Bank president Mario Draghi’s “whatever it takes” speech in July 2012 but acknowledge that capturing the economic step-change in asset markets will require both patience and a nimble approach.
Towards a fiscal union?
Sceptics will no doubt wonder if the European Next Generation Fund is in any way different from some of the other false dawns seen in recent years. In the last decade the S&P 500 rose 190 per cent, while the Eurostoxx 50 rose just 26 per cent — and for dollar-based investors, that modest gain was entirely eaten up by the fall in the value of the euro. So should investors be (re)considering European assets now?
The Next Generation Fund reverses several years of possibly excessive fiscal conservatism at the heart of Europe. While Covid-19 catalysed the announcement of the recovery fund, linking the fund and the EU’s Multi-Annual Financial Framework means pro-cyclical spending will persist well after the pandemic has passed. The fund will also deploy funds according to structural unemployment from 2015-2019 as well as the depth of the growth hit from coronavirus. Not only does this support convergence among European nations’ growth outcomes, it also represents an explicit fiscal transfer from northern Europe to the south and east.
Such a transfer was unthinkable even a few months ago. Despite frequent talk of fiscal convergence and the integration of banking and capital market functions, many analysts expected such convergence was some years off. The progress will not be linear and we anticipate some pushback from several northern European nations but ultimately we believe that strong backing from Germany and France, coupled with clear evidence of the economic stresses the fund is designed to address, will appease any dissenting voices.
Investment implications for European assets
In asset market terms, the Next Generation Fund immediately mitigates the euro breakup risk premium that has lingered in some assets since the eurozone crisis. The jump in the value of the euro indicates that this risk premium is already being priced out. The next area where the breakup risk premium will fall will likely be in periphery government bond yields, and notably Italian BTP vs German Bund spreads. That diminished risk premium, in combination with the easy European Central Bank (ECB) policy and negative net issuance expected in the next year, creates a tailwind to periphery bonds. Despite the recent strength in the euro, EURUSD still trades well below our 1.3800 long-term estimate of fair value. We expect the euro to remain supported, in part, by the growth recovery in the eurozone, and also by more broadly based US dollar weakness. But for the euro to approach our estimate of fair value, we would need to see reserve manager reallocation to the euro as well as a more widespread flow of foreign funds into euro assets.
That said, increased flow of foreign funds into euro assets may take a while longer to play out. After a decade of underperformance, many investors outside Europe have simply given up on the eurozone. We do not expect the outlook for European stocks to change overnight, but we do believe several of the drivers of underperformance over the 2010s are becoming less relevant.
Europe’s banking sector now trades at barely 0.5x tangible book value and is just 7 per cent of the index, down from 20 per cent before the eurozone crisis. U.S. outperformance in the 2010s was technology-led, a sector visible by its absence in Europe. But with looming regulation a growing headwind for the tech giants, and environmental technology becoming ever more important — an industry segment in which Europe is well-positioned — the tech boom of the 2020s may break more in Europe’s favour.
After years of promise and disappointment, global investors will want reassurance that Europe has turned a corner before committing to a major reallocation. In our view, the move in the euro is the beginning of what will be a sequential improvement in the outlook for European assets. We see a positive outcome for European stocks too, while acknowledging that the current sector mix as well as recent history perhaps aren’t so compelling for international investors. But we would equally urge them to reflect that their biggest existential concern — a breakup of the eurozone itself — has been taken off the table.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.