The future of Europe: EU 2.0 and its impact on the markets
- After 60 years of integration, a rising tide of nationalism threatens to pull Europe’s union apart in the years ahead.
- Among the five possible outcomes are some risks for investors.
- More flexibility on immigration is likely to be key to the EU’s survival and the strengthening of support for an EU 2.0 that may be favorable to investors.
This month marks the 60th anniversary of the Treaty of Rome, from which the 28-nation European Union (EU) and the euro currency (shared by the 19-member Eurozone) traces its origin. Also this month, the United Kingdom is preparing to formally begin its exit from the EU—the only full member to ever do so in those 60 years—among a rising tide of nationalist political movements threatening the survival of Europe’s union in the years ahead.
The European Commission, the executive branch of the EU government, has prepared a white paper that presents five scenarios for the future of Europe. Based on a leaked draft of the report, on March 1, the scenarios explore a range of options from scaling it back to just a trade-focused single market to ramping it up into a federal system. We will explore these five options, which of them seem most likely, and what they each might mean for global investors in the coming years.
But, first, it is worth addressing whether there is any reason to believe the EU will survive in any form.
Will the EU survive?
While skepticism regarding the survival of the EU is high, it may not be as fragile as it is often perceived to be.
The debt crisis in Europe (2011-12) exposed flaws, but actually brought the EU closer together rather than pulling it apart. For example, European rescue funds directly recapitalized banks of different countries and banking supervision was taken from the national to the European level.
More recently, the Brexit vote has not led to a flood of other national referendums to leave the EU, as was feared. In fact, support for the Eurozone among the citizens of member nations hit an all-time high of 70% in the latest semi-annual Eurobarometer survey, which goes back 12 years.
Source: Charles Schwab, European Commission data as of 3/5/2017.
The EU has proven to be more resilient than expected by many who have long called for its demise. But, it is facing new challenges from a rise in nationalism/populism, which may result in changes. Polls show that the sharp rise of nationalism in the past few years appears to have it roots in immigration and fear of terrorism, rather than the economics or budget concerns during the debt crisis in 2011-12, as you can see in the chart below.
Source: Charles Schwab, European Commission data as of 3/5/2017.
The influence of immigration on political sentiment can be seen clearly in the polling for the March 15 election in the Netherlands. Just 10 days before the election, the anti-immigration Party for Freedom (PVV) slipped to second place in the polls behind the current ruling party, after leading for months, in step with the rise and fall of immigration into the EU, as you can see in the chart below.
Source: Charles Schwab, European Commission, polling data as of 3/5/2017.
Allowing for more flexibility on border control and management of immigration by EU member nations is likely to be key to its survival and the strengthening of support for an EU 2.0.
EU 2.0 and markets: 5 scenarios
These are the five possible scenarios defined by the European Commission to address the question of what Europe may look like in 2025. All of them carry the expectation that the EU will survive in some form.
- Carrying On: Perhaps the most likely near-term outcome, this scenario is not simply the status quo but assumes some reform in response to the prevailing immigration, defense, and common market issues. The free movement of people within the EU remains, but security is beefed up and border control would be returned to national governments. It also details additional coordination of foreign policy and pooling of military capabilities.
This outcome would likely have the least overall market impact, but may reduce uncertainty over the outlook for the stocks and bonds of Southern European countries perceived to be most at risk from a breakdown of the Eurozone and its institutions.
- Single Market: This most basic scenario strips the EU to its most basic element, making it a single market for goods and services. Trade is the basis the EU grew from and continues to have the broadest support, while everything else would be returned to national governments.
If budgets and monetary policy end up not subject to a supra-national authority, it’s unlikely the euro currency would survive or the European Central Bank (ECB) would have the ability to act effectively in the event of a crisis or economic downturn. This could result in a prolonged recession among some, or all, European nations. The transition to this outcome could be the most potentially disruptive to the financial markets.
- Multi-Speed: In addition to retaining the existing framework as in the Carrying On scenario, this scenario allows for groups of countries to work together on deeper integration while others opt out. With no one-size-fits-all approach, European nations are left to pursue different levels of further integration on specific policy areas, such as defense, regulation, taxation, internal security, or social policy.
This flexible approach to further growth doesn’t address the concerns over the current level of integration, but, were it to occur, may be viewed by the market as similar to Carrying On. A more realistic version of this scenario may be that some groups of nations agree to opt out of some areas of integration in addition to pursuing greater integration in other areas. However, it is possible that this could lead to differences in risk premiums for those “second tier” member nations that do not pursue greater financial integration.
- Focused Integration: An extension of the Carrying On scenario, rather than seeking to further the EU’s goals across a broad range of policies and activities, the EU would narrow its focus for further integration to the policy areas that are viewed more favorably by citizens. The goals may include EU-wide defensive initiatives, such as a European Border and Coast Guard, and negotiation on EU trade deals. Likely dropped goals would be reforms to social policies, employment, and regional development.
Similar to the Carrying On scenario, this scenario may have limited market impact. However, EU member nations collectively deciding on what policies to prioritize and where it should do less would likely be matters of much debate.
- Full Integration: This scenario envisions a United States of Europe with greatly expanded federal powers, including taxation. This outcome would increase integration in all aspects of policy and give more resources and power to the European Commission in Brussels.
Favored by the European Commission, it might seem that this scenario would be welcomed by the markets, ending the uncertainty over the future of the EU and its institutions such as the ECB. However, this scenario seems highly unlikely and any move in this direction would be unstable given the rising opposition by members to even current levels of integration. Markets would likely be skeptical of the durability of any transition towards this outcome in the coming years.
The potentially negative market impacts that could arise with a transition to the single market scenario (and possibly the Multi-Speed scenario if some nations opt out of existing areas of financial integration) would likely show up in several forms. Specifically, widening yield spreads among southern European nations relative to northern counterparts and downward pressure on bank stock valuations in vulnerable countries that are more dependent upon the rescue funds and ECB backstop, such as Italy. In addition, some degree of downward pressure on stock market valuations globally may result from heightened risk to the global financial and economic system.
On the other hand, markets may take some comfort from the Carrying on, Narrower Focus, and Full Integration scenarios, led by sectors such as financial stocks that would benefit from further integration and defense stocks that may benefit from greater collective EU spending.
Step to the future
While the EU and Eurozone are likely to survive in some form, there are future scenarios that hold downside risk for the markets. For now, we remain underweight Europe in favor of an overweight to U.S. stocks. While the form the EU ultimately has in 2025 will take years to determine, the outcomes of elections in Netherlands and France in the next two months, along with the start of Brexit negotiations, may point to a shift in sentiment and mark a step on a path toward one or more of these scenarios. Therefore, for investors, the coming months may be crucial to determining how the market views the future of Europe.
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