April 2019 Chief Investment Office GWM Investment Research The future of Europe The Eurozone and the next recession Content 03 Editorial Publication details This report has been prepared by UBS AG and UBS Switzerland AG. Chapter 1: Business cycle Please see important disclaimer and 05 Cyclical position disclosures at the end of the document. 08 Imbalances This report was published on April 9 2019 10 Emerging markets Authors Ricardo Garcia (Editor in chief) Chapter 2: Policy space Jens Anderson Michael Bolliger 14 Institutional framework Kiran Ganesh Matteo Ramenghi 16 Fiscal space Roberto Scholtes Fabio Trussardi 19 Monetary space Dean Turner Thomas Veraguth Thomas Wacker Chapter 3: Impact Contributors Paul Donovan 23 Bond markets Elisabetta Ferrara Tom Flury 26 Banks Bert Jansen Claudia Panseri 29 Euro Achim Peijan Louis Pfau Giovanni Staunovo Themis Themistocleous Appendix Desktop Publishing 32 The evolution of the EU: A timeline Margrit Oppliger 33 Europe in numbers Cover photo 34 2020–2025 stress-test scenario assumptions Gettyimages Printer Neidhart + Schön, Zurich Languages English, German and Italian Contact [email protected] Order or subscribe UBS clients can subscribe to the print version of The future of Europe via their client advisor or the Printed & Branded Products Mailbox: [email protected] Electronic subscription is also available via the Investment Views on the UBS e-banking platform. 2 April 2019 – The future of Europe Editorial “Whatever it takes.” These words of Mario Draghi’s marked the inflection point in the last recession and paved the way to the present economic recovery. But as the euro celebrates its 20th birthday, the world and investors are beset again by recessionary fears, with risks mounting and likely to continue doing so in the coming years. The growing pains expe- rienced by the euro in its first 20 years and the cloud of uncertainty now hanging over Themis Themistocleous the monetary union raise the question of how and whether it will withstand the next recession. Global protectionism, trade disputes and Brexit woes for example all weigh on investor minds. Therefore, we have decided to convert the long-term study on the future of Europe we released in 2016 into a publication series, and to focus on Eurozone recession risks in the current edition. A new recession would likely lend fertile ground to populists, who have already made good use of the euro debt and immigration crises. Investors are well advised to watch this space, as both the Greek (2015) and Italian standoffs (2018) led to downturns. As the French President Emmanuel Macron remarked, “The world is fracturing, new disor- Ricardo Garcia ders are appearing and Europe is tipping almost everywhere toward extremes and again giving way to nationalism.” What’s more, a recession, particularly a severe one, would likely lead to significant struc- tural changes. Deeply negative Bund yields, Italy being downgraded to sub-investment grade, fundamental shifts in the international corporate tax architecture and the next generation of monetary policy being unleashed are a few examples of what may result from such a slump. Investors bracing for Draghi’s “whatever it takes” need to be pre- pared, because neither he nor other key European policy makers will be in the lead anymore to steer the Eurozone through crisis, even if we would expect integration to accelerate. So the future of the euro will also depend on a new generation of leaders soon to be at the helm of major European institutions and, potentially, in Germany and France too after the new elections. In any event, support for the euro is at all-time highs now, even if a recession could dampen it to dangerously low levels in some countries. It is therefore key that govern- ments pursue their plans to complete the banking and capital markets union with a sense of urgency, while building up fiscal space. In this paper we look not only at the business cycle and available policy space but also stress test the Eurozone with illus- trative recession scenarios. This should lay a good foundation for investors to discover where the weak links and investment opportunities are. Themis Themistocleous Ricardo Garcia Head, EMEA Chief Economist Investment Office Eurozone The future of Europe – April 2019 3 Chapter 1 Business cycle Imbalances within the Eurozone have less- demand. Given its more advanced stage in ened since the euro debt crisis. Outsized the business cycle, the US faces rising current account and fiscal deficits have recession risks in the coming years. Trade largely disappeared mainly thanks to the disputes and Brexit woes fuel further inves- economic recovery. Widespread real estate tor angst. When a more accommodative bubbles at the national level have also van- Eurozone monetary policy stance is also ished, even if hotspots warrant monitoring. factored in, we see greater risk of a global recession than an internally driven slump. But the debt overhang remains, with wide divergences in credit ratings and debt To isolate weak links and investment loads. This should continue to limit Germa- opportunities, we set out three scenarios as ny’s appetite for more fiscal integration. a basis for this publication – an economic With a trend growth rate of just 1%, the expansion, a moderate global recession Eurozone economy is particularly vulnera- and a severe global slump. ble to shocks and slower global foreign Plainpicture/Daniel Ingold 4 April 2019 – The future of Europe Cyclical position Cyclical position A recession would most likely Fig. 1 come from outside Economic expansion from prior peak The current business cycle has lasted exceptionally Underperformance mainly due to 2011–12 recession (Index 4Q 2007=100) long, even if it has been the weakest since the 120 Second World War. The distinctive feature of the 116 Eurozone economy in the current global business cycle is that it has suffered one more recession 112 than most other regions or countries, for instance 108 the US or China. Accordingly, its current recovery 104 effectively dates from 2013 rather than 2009 (see 100 Fig. 1). So the slack in its economy hasn’t been as 96 fully absorbed as has, for example, slack in the US, 92 where headline inflation has consistently exceeded 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 the Eurozone’s since the euro debt crisis. Eurozone real GDP US real GDP Source: Haver Analytics, UBS Looking at our Eurozone heat map, we can see a steady lessening of slack since the last recession, but there is no evidence yet of the economy over- So while the potential for domestic shocks (such heating (see Fig. 2). The output gap and service as the Italian crisis spreading) cannot be excluded, prices are cases in point. What’s more, the Euro- we think any recession that might befall the Euro- pean Central Bank (ECB) has lagged the Federal zone in the next few years is likelier to come from Reserve in exiting its ultra-loose monetary policy. outside rather than from inside it. Fig. 2 Eurozone heat map Economy moving toward late cycle Measure Type 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 p Output gap (OECD) % GDP Output gap (IMF) % pot. GDP Output ga Output gap (EC) % pot. GDP Unemployment gap % Hiring expectations % balance Labor Labour shortage balance % balance Cyclical balance* Fiscal Service Consumer Price Ination % y/y s Hourly labour cost index % y/y Price Negotiated wages % balance Inventory % balance Delivery times % balance Firms Capacity utilisation % balance Equipment shortage balance % balance * Cyclical balance data from 2007 to 2009 are an average of the data for Germany, France, Italy and Spain Source: Haver Analytics, UBS The future of Europe – April 2019 5 Cyclical position Global recession risks building Fig. 3 With the global cycle running since 2009 and out- Global net liquidity injections through asset purchases put gaps having narrowed, global central banks Global central banks on the exit path, in USD billion have reduced their efforts to support the econ- 250 omy. Some, like the Fed, have even started to re- 200 verse them. The liquidity creation stemming from 150 Business cycle asset purchases has dwindled in the process (see 100 Fig. 3), contributing to the recent yield curve in- 50 version. 0 –50 –100 The latter is often regarded by investors and the 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Fed alike as an indicator of risks of an impending ECB BoJ BoE Fed Total recession. Given the importance of US rates to Policy space global ones, in particular those of emerging mar- Note: Total refers to 3-month rolling average of security purchases. Source: Haver Analytics, UBS kets, they also necessarily matter for the Eurozone given it is a fairly open economy. According to a Bloomberg survey (25 February 2019), a majority of economists expect a US reces- Impact sion by the end of 2021. But the yield curve has sometimes given false signals, and today’s interest rate environment isn’t comparable to the pre- Capturing the Eurozone’s future in scenarios quantitative easing (QE) era. Nonetheless, it is fair Even if the US yield curve spread has to be taken to say that the more the Fed tightens beyond neu- with a grain of salt, any warning signals warrant tral, the more such recession risks will tend to preparation, as we might hope for the best but build. Fig. 4 shows these risks trending up over prefer to prepare for the worst. To this effect and Appendix the next one, two and three years. A hard Brexit with recession risks likely to rise in the next few would also increase recession risks.