Fading break-up risks
The euro area continues to face demographic headwinds. In addition, we have the uncertainty of upcoming elections in Italy and France, though we view victories for the extremist candidates, Matteo Salvini and Marine Le Pen, very much as tail risks.
Nevertheless, we see a significant improvement in the underlying structure of the euro area, with real progress towards a proper currency union. In our view, this could be a game changer, which markets haven’t fully appreciated.
Crucially, the new German coalition is providing the euro area with the most significant opportunity yet for a structural shift in attitudes. We think this raises the probability of greater burden sharing across the euro area, with the recovery fund becoming permanent and an acceleration of moves to a full banking union and bloc-wide deposit insurance.
In addition, the new German government’s policy is more tilted towards growth and investment. As well as being more flexible on the Stability and Growth Pact, the coalition seems prepared to accept higher inflation — witness the recent steep rise in German core CPI.
Some improvements predate the coalition. Since the global financial crisis, Germany’s competitiveness gap versus its euro-area competitors has been steadily eroded as its unit labour costs have increased.
While these are all relatively slow-moving dynamics, we look to the revision of the German budget (due in the first quarter) as an early indicator of this change in fiscal attitudes, which is an essential condition for closer union.