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FLASH NOTE ASSET ALLOCATION & MACRO RESEARCH 21 July 2020

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FLASH NOTE ASSET ALLOCATION & MACRO RESEARCH 21 July 2020 PICTET WEALTH MANAGEMENT FLASH NOTE ASSET ALLOCATION & MACRO RESEARCH 21 July 2020 EU: RECOVERY FUND AM IMPORTANT MILESTONE SUMMARY Author › After long days of negotiation, European leaders struck a deal worth €1.824 trillion NADIA GHARBI, CFA in total, including €1.074 trillion for the 2021-2027 EU budget and €750bn for a [email protected] Recovery Plan (labelled ‘Next Generation EU’). › The sceptics will note that big concessions were needed to achieve unanimity among the 27 member states. The amount of grants in the recovery package is lower than in the European Commission proposal of May (€390bn versus €500bn), the European Council also agreed to considerably increase the rebates for Denmark, Sweden, Austria and the Netherlands (aka the ‘frugal four’) while references to the rule of law were substantially watered down. › Nonetheless, the deal remains an historic step toward further integration and financial solidarity. › The agreement reached at the European Council summit overcame the first major hurdle to the deployment of the EU budget and the recovery fund. The next procedural steps will be the ratification of the agreement by the European Parliament and the 27 national parliaments. Habemus a deal After days of negotiations, European leaders struck a deal on the Recovery Plan (labelled ‘Next Generation EU’ or NGEU) and the multi-year EU budget (see press release here). The agreement maintains the €750bn (5.5% of 2019 EU GDP) overall envelope of the European Commission’s ‘Next Generation EU’ proposals from May (see our Flash Note here), but the split between grants and loans has been tweaked in favour of loans given pushback from Netherlands, Austria, Denmark and Sweden (the so-called ‘frugal four’). The final version will consist of €390bn of grants (versus €500bn in the Commission proposal) and €360bn of loans (versus €250bn in the initial proposal). Importantly, the core element of Next Generation EU, the ‘Recovery and Resilience Facility’ (RFF) has been increased to €672.5bn from €560bn, with €312.5bn in grants (up from €310bn) and €360bn in loans (up from €250bn). In more detail, 70% of all grants under the RRF will be disbursed in the first two years (2021-2022) according to the Commission’s allocation key. The final 30% will be disbursed in 2023, based on the severity of the drop of GDP in 2020 and 2021. That amount will therefore only be calculated in 2022. Of note, 30% of the spending through the RFF will need to contribute to green transition. Applying simply the Commission’s allocation key across the whole amount of grants (€390bn) show that Italy would get about €80bn, Spain €73bn and France €40bn (see chart below). Countries requesting funds will have to submit a “recovery and resilience” plan which will then have to be approved by the European Commission and the Council by a qualified majority (and not by unanimity as Dutch prime minister Rutte wanted). Nevertheless, an “emergency brake” can be applied and review undertaken if it is thought that a recipient country is not fulfilling the “agreed milestones and targets set out 1 OF 5 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 21 July 2020 EU: RECOVERY FUND AM IMPORTANT MILESTONE in the recovery and resilience plans”. The review process by EU leaders would take no more than three months, with the European Commission retaining the final say. EU RECOVERY FUND: ALLOCATION IN GRANTS APPLYING THE EC’S KEY (ROUGH ESTIMATES) 90 EUR bn 80 70 60 50 40 30 20 10 0 Source: PWM - AA&MR; European Commission As part of the agreement reached at the summit, the Commission will be authorised to borrow up to €750bn on capital markets on behalf of the EU. The funds raised will be repaid through future EU budgets— not before 2028 and no later than 2058 and via certain new own resources. One of these resources will be a new tax on non-recyclable plastic waste to be applied from 1 January 2021. Plans for other new resources is much sketchier. Bonds issued by the European Commission will be eligible for the ECB’s asset purchase programmes. In other words, a portion of Recovery Fund bonds will likely be bought by the ECB. Concessions were necessary One lesson from the long drawn-out negotiations are that while the Franco-German alliance was necessary it was not sufficient to reach an agreement. To get the ‘frugal four’ on side, several adjustments had to be made to the initial proposal. Rebates. Apart from the reduction of the amount of grants, member states agreed to boost the budget rebates the ‘frugal four’ receive on their contributions to the EU budget. Originally, the Commission hoped to abolish all rebates post-Brexit. Per year, Netherlands, Sweden, Austria and Denmark will get 1.9bn, 1.1bn, 565 million and 377 million respectively. The German rebate remained unchanged at 3.7bn per year. Rebates total around 53bn over the seven-year budget period. These gross reductions will be financed by all Member States, reducing the net transfer effect. Rule of law. Following a pushback by some Eastern countries, references to respect for the rule of law were substantially toned down in the final proposal. The agreement now simply states that the European Council “underlines the importance of the respect of the 2 OF 5 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 21 July 2020 EU: RECOVERY FUND AM IMPORTANT MILESTONE rule of law”, without overtly mentioning the possibility of blocking disbursements if the rule of law is not respected. Agreement at the European Council summit was the first major hurdle to overcome before the EU budget and recovery fund can be put in place. The next procedural steps will be ratification of the agreement by both the European Parliament and the 27 national parliaments. A big political moment for Europe after all The deal is not perfect and the fierce debate to seal it did not send a signal of strong unity. But the 27 did at least reach an agreement. To quote Jean Monnet, “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” Indeed, some critical design flaws in the EU’s functioning have emerged in recent years. But as a rule, each crisis has sparked progress towards more integration. Covid-19 may be no exception. 3 OF 5 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 21 July 2020 DISCLAIMERS Distributors: Banque Pictet & Cie SA, Route des Acacias 60, 1211 Geneva 73, Switzerland and Pictet & Cie (Europe) SA, 15A, avenue J. F. Kennedy, L-1855 Luxembourg/B.P. 687 L-2016 Luxembourg. Banque Pictet & Cie SA is established in Switzerland, exclusively licensed under Swiss Law and therefore subject to the supervision of the Swiss Financial Market Supervisory Authority (FINMA). Pictet & Cie (Europe) SA is established in Luxembourg, authorized and regulated by the Luxembourg Financial Authority, Commission de Surveillance du Secteur Financier. 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