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 downturn in Europe compared to other developed economies.
The first quarter GDP data confirmed these expectations, with Europe contracting by 3.6 per cent on a quarter-on-quarter basis, while the US contracted by 1.3 per cent. Economic projections for the full year show a similar divergence, with Europe expected to contract by around eight per cent and the US by around five per cent.
The divergence in expectations is mainly explained by the improved economic fundamentals in the US going into the crisis, the stronger and more coordinated policy response and 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 economic indicators, the pick-up in activity has been remarkable in both 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. Purchasing Managers’ Indices (PMI) flash composite estimate in the euro area increased 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 economic reopening 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 several states to reimpose lockdown restrictions. The surge in cases seems to be driven by a faster rate of contagion given the increase in positive test rates, despite the enhanced testing capabilities across states.
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. Moreover, the fallout in labour markets is expected to have more long-lasting effects which increases the risk of hysteresis in the US recovery.
Improving growth and accommodative policy may bode well for European financial markets
The policy response in the US has been swifter and larger with the onset of the crisis. Congress had quickly agreed on a stimulus package equivalent to circa 13 per cent of GDP, while the fiscal reaction in Europe was more modest across member states, averaging at four per cent of GDP.
The Federal Reserve Bank (Fed) cut rates by 150 basis points 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 short-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. This led to the ECB’s decision in June to substantial increase its QE programme.
Moreover, while the fiscal response remains fragmented across 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 assist sovereign states.
The higher degree of risk sharing that the combination of these policy measures may provide could put Europe in a strong position to see a faster and steadier economic recovery. But 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 ECB’s purchase programmes relative to the size of the government bond and corporate bond markets is expected to provide a greater direct effect on bond yields.
Moreover, positive cyclical developments and supportive financing conditions are expected to sustain the compression in market risk premia and uplift valuations in risky assets.
Matthias Busuttil is head, Investment Strategy and Research at Curmi and Partners Ltd. 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.