Transcript

Tom Liebi Hello everyone and welcome to our latest episode of our Topical Thoughts podcast. I'm Tom Liebi, Head of US and UK market strategy at Zurich and I'm here with Ross Hutchison, Head of Eurozone market strategy and Ross just published a topical thoughts paper on green shoots in the old continent. Now Ross, tell me, you're writing about green shoots, about the European economic renaissance, so it sounds very optimistic, so what are you telling us? What's happening in the Eurozone these days.

 

Ross Hutchison Thank you very much for the kind introduction. I mean exactly as you say, this piece is, it's an optimistic piece I think more broadly, but I think we should say it's not unrealistically or unaware in its optimism, i.e. there are very clearly risks around this outlook in Europe. Nevertheless, you know, in our opinion, there are some genuine positive developments that we have seen that lead us to essentially upgrade our medium and longer term outlook for a European economic growth perspective. We've also seen some good news, I would say, by the way, more broadly on inflation coming down, the ECB is cutting rates, all of this is a little bit positive overall, but not unreservedly so as we go into.

 

Tom Liebi So, that sounds definitely quite positive because we are kind of used a little bit to have more modest news maybe from the old continent as you also pointed out in the past, but what has triggered this new optimism now? What has happened recently? What would you like to point out to our listeners?

 

Ross Hutchison So there are, I would say, two things running in parallel here right now. So the first one is, we actually released a piece last year on the Draghi report, which is incredibly kind of well-rounded, very detailed report on the fact that something fundamentally needs to change in the European Union with respect to its rather underwhelming I mean, perhaps that's an understatement, rather underwhelming economic growth, realized economic growth relative to areas such as your markets, such as the US, for example. And we have seen some progress with respect to that report, certainly in a mentality sense, but even from the European Commission's perspective on a variety of pieces of legislation that's discussed and focused on simplification, on deregulation. So there's that element of it. And then there's a secondary element, which was really a surprise and has really pushed forward to this story of optimism, which was following the German elections earlier this year, snap elections that were called, there was a surprising, essentially historic announcement of fiscal loosening in Germany. So that's come from the CDU & the CSU, the center-right party, you know, who were extremely instrumental in creating the debt break in the first place, they've now actually kind of loosened that significantly and that's a real, real positive when we look at our economic forecast going forward, something I think frankly was sorely needed in Germany, if it is spent well.

 

Tom Liebi No, absolutely. I mean, I did read your paper and you point out this is definitely a game-changer. I mean you talk about increased fiscal spending in Germany. There are obviously a few questions that pop up in my mind initially. First of all, what measures or where will the focus be of this fiscal spending? That's definitely a crucial question. Will it be a one-off or will it really help to lift longer-term growth potential? And the second question is - will it probably most likely to be focused around within Germany, but will there also be positive spill-overs to the rest of the Eurozone?

 

Ross Hutchison So, on the first question there, on the design, certainly from a holistic perspective from us, we certainly hope that the focus, and we write this in the piece, that the focus needs to really be on increasing long-term potential growth in Germany. And that, by the way, much like in most of Europe, means overcoming the drag of demographics. So essentially we need to find a way to increase what we call total factor productivity growth, essentially getting more per worker. And I think there are a variety of ways that that can be achieved in Germany. And there's kind of a two-pronged approach to this thing, the fiscal package here. So on the one hand there is this very very large number, 500 billion euros, that is specifically to be allocated to this infrastructure fund and the intention here is to spend that over 12 years. And essentially this number has come up basically with some economists, economic experts who are cross-party and party-affiliated German experts saying what is the estimates of the under-investment that has occurred, or in this case not occurred in Germany over the last many years, and what do we think we need to spend in order to make up for that. So this is all infrastructure spending in transportation links, in energy links, some eventually related to climate and the energy transition. When you look at the kind of historical classical multiplier numbers, you get that these kind of infrastructure spending, you can be fairly confident that they're going to have a pretty positive impact on the economy because we know Germany has underspent in this sense, i.e. Investment has been lower than comparative markets. The second point, and this is where there's a lot more variance around how positive this is going to be, although we do land that it will be positive, is on the defense spending piece. There is essentially an open-ended commitment here to any spending on defense that's in excess of 1% GDP is exempt from the debt break entirely in Germany. So we're looking at numbers possibly 3%, maybe even 5% is being discussed for NATO. I think the numbers that I think look realistic right now is a medium term 3.5% figure that we're going to get to in the coming years. If spent well, and we kind of talk about this in the piece, this is essentially research and development spending that can hopefully have these positive externalities with respect to civilian use that's very hard to know beforehand but hopefully you can have that then this could be a real real game changer for basically a kind of inflection higher significantly in growth because of all this technological overspill in robotics and drone technology etc etc. Just quickly to answer your second point there is boosting consumption and business investment generally in Germany, which is what I clearly think will happen on the back of this historically large fiscal package, should very clearly have a spillover to the rest of the Eurozone through that increased consumption investment, i.e. ex-German firms and businesses generally, but within the Eurozone, should expect to benefit from this level of increased activity generally. Procurement should also opportunity should come for European firms generally as well. And then there is this the second piece which is also although Germany's biggest, the single biggest you know chain that we've seen with respect to fiscal policy, there are other countries that are essentially through the defense channel talking about more fiscal spending generally, which is happening at a broader European level as well. So this is that angle both the extra defense spending and the boost from Germany spilling over that should impact the other countries, possibly.

 

Tom Liebi Obviously that just, I mean, I would like to follow up with many other questions because it's definitely a very hot topic at the moment, but maybe let's stick to just what you said in the end. What does, I means it sounds like a kind of a significant rise in fiscal deficit. Obviously, you pointed out in the beginning that Germany has some leeway, but what does that mean for the fiscal situation, for the deficit, for the debt sustainability? Is the AAA rating at risk at all or what does it mean?

 

Ross Hutchison So the one positive thing that I would start with here is that we are already seeing rating agencies take this new information into account, and they haven't changed the rating, they haven't changed the outlook on the rating. So S&P, at the time of us recording here, just last week they reaffirmed Germany's rating at AAA. That, of course, doesn't mean that there are no risks around this number, but just to kind of talk about the numbers, Germany has, debt to GDP slightly above 60%. Has generally run deficits because of its debt break that are positive in a sense. So it's structurally been close to zero, not quite close to 0. And of course, during COVID, that did widen out, but not as much as others, and it's come back more quickly than others as well. But the key point here is, when you look at projections of that number in the future, what's going to happen really, relies on what the fiscal multipliers of this actual spending is going to be. So you can paint negative scenarios where a lot of money is spent very poorly i.e. in things that don't end up leading to persistent potential growth increases, or you can even come up with scenarios where actually the spending is so powerful, but it ultimately even reduces debt even faster than it was going to anyway. Now, I would say we sit somewhere realistically in the middle of that, but I would lean more towards the positive side of it. I think you will see debt and deficits both increase in Germany in the short term, the next, let's say, few years, two, three, even further out. But ultimately, I do think that it will stabilize at a reasonable level, and I also don't think you're seeing a, shall we say, permanent shift in the fact that, I mean, German politicians and voters overall still do have an aversion to debt. I think that it's certainly higher than in other European areas, and that will be coming back down again, I would expect as well. So I would be quite positive on that, but of course there are risks.

 

Tom Liebi And of course, I mean, you mentioned it. It's a bit of a, well, it is a game changer. It's really kind of took some time, but now it seems that in Germany, they are willing to increase fiscal spending. There will be spillovers, positive spillover to the rest of the Eurozone. But what do you think, will it also help this renewed kind of, well, this openness to more fiscal stimulus? Will it also lead to kind of more broader moving together within the Eurozone, talk about the Capital Markets Union, about common debt issues, any thoughts on that topic in this direction?

 

Ross Hutchison I think that's a great question. I think it's a super complex area, so I'm not going to take about three hours to answer this now, but I'll try and do this as succinctly as possible. I mean, I think there is actually some complexity here with what Germany is doing in two regards. Firstly, Germany has historically been one of the most vocal critics of fiscal spending, historically, in the Eurozone crisis. And there's no irony lost in a few nations who perhaps look at Germany and say, well, how do you think it's appropriate to be breaking possibly the fiscal rules around this, for example, the Stability and Growth Pact doesn't allow you to have more than 3% GDP as a deficit, well Germany's plans do suggest that that is going to happen and for possibly a sustained period of time around that level as well. I think ultimately the pragmatism around the geopolitical situation outweighs those concerns. And what I mean by that, we talk about this in the piece. We have seen since the Covid crisis really an enormous but quite quiet growth in what may be becoming a new risk-free asset or kind of possible substitute in the future of a risk- free asset in the eurozone through the EU denominated bonds. We're almost getting towards and likely projections are we getting towards a trillion in those outstanding in coming years and I think that the nature of this coordinated defense push across NATO members and allies is likely to see conversations going towards some more joint risk-sharing around that kind of fiscal push there in general. So I think that the specifics of the German decision themselves have some complexity to them, but I think that's outweighed by the very, very positive sense of, I guess, kind of shared risk in the world generally that's pushing a lot of European Union and allies closer together in that sense.

 

Tom Liebi That sounds convincing. Maybe let's briefly touch a different topic, given that I have you here, Ross, and there's a lot going on. We've talked more about long-term promises and prospects of lifting growth, but we all know near-term is relatively uncertain. I mean, there's lots of talk about tariffs, US tariffs. There are ongoing negotiations, and it seems like President Trump has a particular focus on the European Union. What's your view on that topic? I mean, it probably, there are two different topics, but still they kind of mix in because both are related to growth and uncertainty.

 

Ross Hutchison Absolutely. So, I mean, I started at the beginning by saying paragraph one is optimistic, then paragraph two sets out some kind of, you know, pours a bit of cold water from the realities. And then, I mean, the real end to that comes, a real negative shock comes I think in paragraph three, which is essentially saying the near term outlook, I mean, genuinely isn't very good. And that's primarily from an expected tariff shock that will come there. The European Union has increased its dependency on the US as an export market over the last few years. China has actually become less relevant for the EU in that sense as an export market. So inevitably there are going to be some negative consequences because of this trade war and these tariffs that are coming through. Where the view is though ultimately is that this represents more of a kind of one-off shock and actually in a sense is the kind of shock that Europe needs and a lot of these things are happening are shocks that Europe needs because it should change and we're already seeing that happening through the rhetoric and these policies generally, for example, is fiscal policy. It should be less about net export-driven growth, and it should be more about consumption, domestic investment to really rebalance that economy in a world that is genuinely turning more and more away towards, I should say, friendly general market terms for trade.

 

Tom Liebi Maybe take it one step back and putting everything in perspective looking at the bigger picture. We also know from the past that Eurozone obviously had its struggles, but it usually tended to grow together, make a step forward in times of crisis. And this seems to be, I would say, one of these times. So if you look at the geopolitical situation, the tariff situation, growth prospects, so, this seems to be a bit of a wake-up call, a chance to really improve the near-term, particularly also the long-term future. So do you think this is really a big step now or do we face the risk of, let's call it bluntly, over-promising and under-delivering?

 

Ross Hutchison I think that risk is very clear and present, but I do fundamentally think that we have seen such a significant positive change in mindset because of the realities that we're seeing now, because of essentially the untenable nature of kind of the economic underperformance and some other pressures that have been building up that there are going be persistencies to this positive pressure for change. So I guess one thing that I'd just like to touch on as well very briefly is - we are seeing at European Commission level and at some national government levels, a shift in mindset away from what I would say is a kind of regulate first ask questions later to more of a recognition of the trade-offs that regulations can bring. I don't want to kind of create the sense that it's purely deregulation is a virtue in itself, but I think often you've found that with some legislation within either the European Commission level or more broadly within across Europe the focus has been less on achieving that kind of sustainable, persistent economic growth and really the burden on firms has grown really in some cases to quite immense levels in terms of reporting requirements, in terms of uncertainty around, you know, how exactly legally you can interact with new technology such as AI, for example. And I think there is a huge mindset change there. You see that in the European Commission's Competitive Compass. For example, you've seen things like the Omnibus simplification packages, which are trying to alleviate these burdens. I think these may not be perfect, what they're doing, but I think the mindset shift is enormous, and is really night and day compared to where we were just a few years ago.

 

Tom Liebi That is very reassuring to hear. Thank you very much, Ross. And there are definitely green shoots in the old continent, as you say. And we are hoping to see a European economic renaissance here. So I think we come to an end here for the podcast. But once again, I would remind you all there's much more on this topic and our topical thoughts paper to be found on Zurich.com. Thank you very much, Ross, for joining me here. Thank you everyone for listening in, tuning in, and, definitely looking forward to the next episode of our podcasts. Goodbye, everyone.

 

Ross Hutchison Thank you very much, goodbye.

 

 

 

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