When is the next recession? How would Europe cope?
These questions are both weighing on investors' minds as fears of a recession grow.
A recession, particularly a severe one, would likely lead to significant structural changes. These may include fundamental shifts in the international corporate tax architecture and the unleashing of the next generation of monetary policy. Investors bracing for Draghi’s “whatever it takes” need to be prepared, because neither he nor other key European policy makers will be in the lead anymore to steer the Eurozone through crisis, even if integration accelerates.
To help investors, we look not only at the business cycle and available policy space, but also stress test the Eurozone with illustrative recession scenarios. This should lay a good foundation for investors to discover where the weak links and investment opportunities are.
The Eurozone’s future
Eurozone growth scenarios
Real GDP growth, in % year over year 1970
Will the next recession be any different?
To isolate weak links and investment opportunities, we set out three scenarios as a basis for this report – an economic expansion, a moderate global recession and a severe global slump.
Economic expansion scenario
In this scenario, central banks ultimately manage to bring about a soft landing for the economy overall by normalizing monetary policy without causing a downturn.
Moderate recession scenario
In our second scenario, we look at the implications of a more moderate globally driven economic contraction. Its impact is assumed to be relatively shallow as central banks and fiscal authorities mitigate it in a timely manner, and as relatively few excesses have built up in the current Eurozone business cycle.
Severe recession scenario
In our last scenario, we go one step further and again assume a globally driven contraction of the Eurozone economy, but this time one similar in magnitude to that of the last global financial crisis. Severe recessions have historically stemmed from factors such as real estate busts, financial crises or commodity shocks. In this case a major Eurozone slump would likely have to be driven by a harsh US downturn and a hard landing in China.
Key potential surprises and weak links in a severe recession:
Sovereign ratings limit fiscal space, forcing austerity upon Italy, Portugal, and Greece.
Italy at risk of drop to sub-investment grade rating, forcing adjustments which could deepen the slump.
Investors would demand high risk premiums for the less-liquid bonds of lower-rated peripheral countries, where debt loads would in many cases reach record highs.
Eurozone banks would enter into an extended restructuring period. The combined efforts of shareholders, creditors, governments and the ECB would be necessary to restore stability.
Monetary policy 3 would probably need to include new levers, for example equity purchases, helicopter money and deeply negative policy rates.
Market to question euro membership of Italy, Portugal and Greece.
In any event, support for the euro is at all-time highs now, even if a recession could diminish it to dangerously low levels in some countries. It is therefore key that governments pursue their plans to complete the banking and capital markets union with a sense of urgency, while building up fiscal space. Investors are well advised to closely follow the imminent changeover among European leaders, as they will likely be the ones to re-write the rules that govern the euro.