Thoughts through the cycle: W5 May ’20

Share on facebook
Share on twitter
Share on linkedin
  • In this week’s hit-parade of contrived historical analogies, Europe has claimed the top spot. To much rejoicing in the press, it seems that the joint Franco-German announcement of a €500b pandemic recovery fund on the 18th May was Europe’s ‘Hamiltonian moment’ when the decisive shift to joint bond issuance (and therefore burden sharing) was made. In 1790, Alexander Hamilton proposed that the debts from the American war of Independence owed by individual US states be amalgamated and paid off by a shared, US Treasury. Perhaps it is too early to speculate whether Angela Merkel and Emmanuel Macron will, after their moment of triumph, have an opera written about them as Hamilton has. First, it is necessary to cut through hyperbole to analyse what has happened so far and what happens next.
  • Context is everything. The recent ruling by the German Constitutional Court (GCC) suggesting the ECJ has failed in its oversight of the ECB’s execution of monetary policy has clearly been a major shock and one which potentially means the Bundesbank’s participation in ECB policy cannot be taken for granted. The ECB is assessing how (or even if) it will respond, and the clock is ticking on the three-month deadline set by the GCC. Germany takes over Presidency of Europe on the 1st July, heightening the focus on the country. The dire progress being made by the European Commission (EC) with respect to Brexit negotiations might well provide another salutary reminder of the centrifugal forces being applied to Europe, not least when the UK is a major export market for Germany.
  • What about the actors? France’s Macron has long been pushing for closer fiscal union expressed through joint budget commitments, so there is no real change of tack from him, although the size of the current proposal (€500b) seems modest given his previous assertions of what is necessary. More interesting is the German Chancellor, Merkel. It seems the joint Franco-German announcement on the 18th May amounted to a considerable volte-face for Merkel, surprising her German colleagues, although many have since rallied around her, most notably the arch-hawk of the Eurozone crisis, former German Finance Minister, Wolfgang Schaüble. Merkel has form with respect to spectacular announcements of unilateral policy decisions – foremost on this list is her politically-disastrous decision in 2015 to declare Europe’s borders open to Syrian refugees without consulting her neighbours. There is also a sense that the ‘push-me-pull-me’ nature of European policy sometimes demands major assertion which is then followed by consensus-building to the backdrop of disagreement courting market disapproval and therefore disaster. Mario Draghi was the master of this, both in his 2012 ‘whatever it takes’ speech, as well as his announcement at last year’s Sintra meeting of the resumption of quantitative easing (QE) without having consulted his colleagues on the ECB board.
  • There is also a special significance to joint announcements by France and Germany. Diplomatically, it is very hard to resist the combined weight of these two countries acting in unison. The ‘Merkozy’ duo of Angela Merkel and Nicolas Sarkozy provided the fulcrum of decision making during key moments of the Eurozone crisis, most notably during the bailout of Greece in May 2010 and with respect to forcing Italy’s colourful Prime Minister, Silvio Berlusconi, from office in 2012. While the ‘frugal four’ (Austria, Netherlands, Denmark and Sweden) immediately responded to the recent Franco-German proposal by insisting on loans and not grants, one wonders how long this resistance can hold out against the usual back-room arm-twisting that goes on. It is also worth noting that the 2010 Greek bailout turned out to be a bailout of the French and German banks, which left Greece as a ‘debt colony’. More time needs to be spent thinking about how France and Germany now benefit from these proposals, especially France with its colossal debt mountain of over 320% of GDP[1] (public and private).
  • So what was actually announced? A €500b recovery fund with a digital and green focus to aid recovery from the Covid-19 pandemic. This would come from the EC budget and would not be allocated according to budget contributions although repayment would be proportional to this. The proposed fund can be levered, giving the EC new powers to issue bonds. The German press release did not mention grants (as opposed to loans), while neither Merkel nor Macron seemed to mention grants during the press conference. Indeed, Macron’s actual words were, “This recovery fund of €500b is not going to be a grant to a region or sector, but it is going to be a budgetary aid.” Despite this, the declaration was widely reported as Germany advocating grants that need not be repaid, and that this meant shared debt issuance and the road to joint-and-several issuance (such matters would likely mean treaty changes, unanimous parliamentary approval across the EU-27 and also specific approvals from the likes of the German Constitutional Court – no matter though). The immediate response from those opposed to mutualisation (Netherlands et al) was that aid had to be in the form of loans not grants, suggesting either that the proposal was about grants, or that they were laying out their opposition to grants as this matter had yet to be finalised. With the formal EC proposal on the 27th May, the next European Council meeting is on the 18th June, so there is clearly some time for this narrative to develop.
  • What has the reaction been? The EC is clearly elated as any bureaucracy would be with the addition of bond buying to its suite of capabilities. The ECB is also once again on the front foot, with economist and board member Philip Lane hinting strongly in a speech on 22nd May that the ECB will announce further bond buying at its June board meeting. This has to be taken as a poke in the eye to the GCC and a further assertion of the ECB’s power. It is worth noting that the ECB will be able to buy up to 50% of the bonds issued by the EC (higher than the 33% limit on sovereign issuance).
  • Italy’s Prime Minister Conte has already said that the new pandemic fund would mean Italy would not need to access the politically-toxic European Stability Mechanism (ESM) for funds. It is worth noting in passing how easily a fund like the €540b ESM can be thrown on the scrap heap without having been accessed. This is particularly true in Italy where the cheap funding of the ESM (average 0.76%[2] since inception) has been ignored in favour of the market (note a €22.3b Covid-19 emergency ‘retail’ issue by Italy at 1.4% on 21st May). Clearly this is an example politics trumping purely budgetary considerations.
  • The ‘frugal four’ are clearly digging in for a fight over the issue of grants versus loans. In a radio interview on 23rd May, Austrian Chancellor Sebastian Kurz said, “We believe that there needs to be a discussion about how much of those 500 billion are grants and how much are loans…how we give this aid [demands] a clear and binding time limit, so that we don’t have a full debt union as the next step…At the end of day there needs to be a compromise, that’s how the EU works,”. A predictable reaction – loans not grants, limited scope, limited time-frame, no mutualisation. So not quite a done deal yet it seems.
  • Most importantly, what about the market? If this is the start of a major European reflation effort, the market is being a bit half-hearted in its response. Euro 5y5y inflation (5yr inflation in 5yrs time) has risen 6 basis points to 0.90% (NB the ECB’s medium-term target is 2%). The graph below shows German 10yr yields having risen 5bps or so since 18th The 10yr spread between Italy and Germany has tightened a little to around 210bps, but this is far short of a real ‘convergence’ trade, and probably little more than some short covering.

Source: Bloomberg, 25th May 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Perhaps the muted response is due to a combination of immediate dissent from some member states (and accession countries such as Poland) as well as the modest size of the fund at € The EC was suggesting a €1T fund. Spain was demanding a recovery fund of €1.5T. The US has already executed a combination of fiscal and monetary intervention in excess of $10tn. In any case, the new EC fund, should it be agreed, will only become active in 2021 and it may provide relief, but that is a somewhat lethargic interpretation of ‘emergency’. The delay is because the fund is part of the ongoing multiannual financial framework (MFF) budget negotiations. These were already floundering over how the gap left by the UK after Brexit would be filled. One senses that further extending this budgetary scope is not going to make for easy negotiations in the midst of a deep recession.
  • The press reaction has been euphoric at times. In an article entitled ‘Europe’s Hamiltonian Moment’ for Project Syndicate (21/05/2020[3]), the economist Anatole Kaletsky co-opts George Soros’ recent suggestion that Europe should issue perpetual bonds and goes on to speculate that;

“To put it another way, if the EU borrows €500b this year for a European recovery fund, then it could easily borrow another €1 trillion next year for a digital inclusion fund, and then maybe €2 trillion for a vehicle electrification fund or €3 trillion for a comprehensive climate-change fund. Such simple calculations show why European economic and political conditions could be completely transformed by the Merkel-Macron plan’s financial innovations.”

Adding that:

“a compromise acceptable to both sides should not be difficult to forge. The size of the recovery fund could be increased to something near the €1tn recommended by the European Commission without imposing any strain on the EU budget. But in exchange, the Frugals could insist on offering 50% of the support through loans instead of grants.”

  • While such vaulting ambition is to be admired, it does tacitly admit that the current €500b is completely inadequate for the job in hand. If Kaletsky is suggesting that this is just a precedent and therefore some sort of Trojan horse for joint-and-several issuance, he may want to consider more closely not only the existing opposition from the ‘frugal four’ but also the recent judgement of the GCC on the ECB’s QE. It seems most unlikely that the German constitution and the Lisbon Treaty can be bypassed in a single session of EC budget negotiations. It is worth noting too that Germany has already pledged over a trillion euros to relief efforts in its own country – the appetite for infinite financial engineering would seem to go against the grain of much of German politics.
  • More broadly, for those who want to seek out precedents for the effect of aggressive fiscal spending on growth and inflation, one need to look no further than Japan. This is a country with many bridges to nowhere and very fast trains travelling over them, but with a 10yr zero coupon inflation swap (a good market indicator of long-term inflation) which has fallen to -0.18% in 2020. Fighting debt-deflation with more debt might not be an obvious choice to reflate an economy.
  • Were this Franco-German proposal to pass and become part of the EC’s budget, then from a €500b fund Italy might get 1 or 2% of GDP in terms of grants (or loans – we don’t yet know for sure). This is not a huge amount of money. Perhaps this is why the market seems a little less enthusiastic than the pro-European press corps. It is sometimes suggested that for real burden sharing (joint-and-several issuance, common bank deposit insurance, a substantial EC budget beyond its current levels etc), then there would be spread convergence between EU bond yields. One suggestion as a rule-of-thumb would be that overall, the French and Italian yields would meet somewhere in the middle. 10yr France yields -0.05% and 10yr Italy 1.58%. There is clearly some way to go here.
  • What awaits us is the high drama of the EU budget agreement, now given special significance by the Franco-German proposal. As ever with Europe, it is not only a question of doing the right thing, but enough of the right thing before it’s too late.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as a 2nd June 2020.

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Explore more

Thoughts through the cycle: W2 January ’21

In a fragmentary work on the philosophy of psychology published in 1953 after his death, Ludwig Wittgenstein addressed the phenomenon of how our impressions of what we see…


Please confirm your investor type



By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER

This website uses cookies. A cookie is a small data file placed on your computer which captures information about your choices which allows us to improve your experience of the website, for example, by remembering your country of residence. By continuing to access this website, you agree to be bound by our Cookie Policy. You can accept and/or block at any time by changing your browser settings.


Where are you located?



Rest of world

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER


What type of investor are you?



By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER