How To Make The Most Of The European Recovery Fund

The EU Council's president, Charles Michel

Morgan Stanley | The Reconstruction Fund will be the main catalyst for a synchronized macroeconomic recovery in the European Union. The periphery is the area most affected by the virus. It has the highest share of exposure to the most impacted sectors, so is the European region facing the largest contraction. Neither does it help that the fiscal capacity of these countries is limited by high levels of debt and greater financing costs.

So this response will mainly be aimed at helping the most affected and indebted countries. Firstly, through the ECB’s action (via the PEPP programme to contain spreads and facilitate fiscal solutions). Then, secondly, through the Eurogroup’s package of measures, SURE, EIB and ESM (cheap off-market financing). Finally, and most importantly, through the Recovery Fund.

For the time being, the Fund is still only a proposal and there remains a wide divergence of views regarding the amount, duration, allocation, grants/loans etc. Whatsmore, as unanimity is required for its approval, there is a risk the fund will eventually be vetoed by some countries. That said, our expert EU analyst, Jacob Nell, is still confident of its approval for 3 key reasons:

  1. Historical evidence shows that when Germany and France are in strong agreement over a policy, it is highly likely it will eventually be approved.
  2. The programme is not free money, but almost: rate strategists estimate that the European Union will only be able to issue debt at a small yield premium over other major nations. In this case, the region would be able to issue debt with a negative or flat IRR for up to 15 years maturity in accordance with current market prices. In other words, if Europe issues €750 billion, the costs of issuance would be significantly below €5 billion per year and even potentially below €1 billion. Furthermore, there will be no repayments until 2028 (way beyond the horizon of most national legislatures). And there will even be the option of rolling over debt repayment.
  3. A possible failure in the negotiations would put strong growth pressures on the periphery, thus reviving concerns about the major divergences in the region.

With all this in mind, Jacob Nell assumes that the final outcome will be in line with the Commission’s proposal: €750 billion in joint issuance (500 billion in grants and 250 billion in loans). With regard to the use of these funds, he believes the optimal scenario would be one where spending is applied through investment since it has a higher fiscal multiplier (vs for example a tax cut to companies or transfers). Particularly if this is focused mainly on the “unconstrained” sectors rather than the more impacted ones, such as the digital and green-biased sectors.

With regard to strategy implications, the main effect of the Recovery Fund will be, more than the generation of macro growth, the reduction of the risk premium associated with the EU, with the subsequent positive impact on equities. The main beneficiaries will be those sectors exposed to the periphery and to green activities. In line with this, our EU strategists have prepared 3 value filters to play the Recovery Fund:

1.Beneficiaries of higher growth and lower risk premium: Cyclicals generate more than 40% of their income in the EU and would benefit from a strong EUR/USD, rebound in IRRs and peripheral spreads. Amongst the stocks with an Over Weight recommendation are names such as ArcelorMittal, Renault, Valeo, Randstad, Prysmian, Eiffage, Amadeus, Bouygues, Evonik, Capgemini, Vinci, Deutsche Post, Alstom, Ferrovial and Ferrari. 

2. Securities with exposure to the periphery (all with Over Weight recommendations): Caixabank, Mediobanca, ENEL, Cellnex, Unicredit, Santander, Vodafone, Carrefour, Credit Agricole, Airbus, BNP Paribas, GVC Holdings, Ubisoft and Yara.

3. Stocks to play for greater fiscal spending by governments: Ferrovial, Veolia, Eiffage, RWE, EDP, Knorr-Bremse, Bouygues, Capgemini, Engie, Prysmian, Alstom, EDF and ENEL.