Andrew Milligan: Will grass be greener after Brussels summit? Published on Thursday 28 June 2012 00:00 DIFFICULT issues must be tackled on the European economic front if any recovery is to take hold. If European policymakers were playing a grand game of golf they would currently be knee-deep in the rough, with no line of sight to the green. As anyone who has had the misfortune of being in such a predicament will know, the options are extremely limited. Either you can gamble on a miracle shot or you can muddle through, play out sideways and hope things will look a little better from the fairway. The latter option is what we can expect during the EU summit which begins today in Brussels. Certainly, this appears to be the growing expectation among market participants. Equity markets have recently been stuck in a narrow trading range, with the trend downward if anything as pessimism encroaches. The yields on eurozone government debt, a key indicator of the market outlook on Europe, also provide few clues that a significant policy change lies ahead, with Spanish and Italian yields creeping higher. Finally, the US dollar index has edged upward in a sign that risk appetite remains muted. Investors would be wise not to misinterpret the current market pause as a sign that some stability has returned. In fact, there will be extremely important issues in play over the next few days, with the outcome of the summit potentially providing the longer term investor with useful indications about the direction of European integration. Conversely, failure to reassure global investors on the eurozone's future plans could have very serious consequences, plunging markets back into the difficulties witnessed in recent months. So what are the key areas to watch? Indeed, what would markets like to see to demonstrate that politicians are ahead of the curve? The most well-flagged outcome from the summit is likely to be the announcement of a "growth compact," probably around €120-130 billion in size, ostensibly to relaunch investment and create jobs. This has been championed by French president Francois Hollande in an attempt to redress the balance between "austerity" and "growth." Will it be enough? We doubt it will have a major effect. The package is largely a redirection of existing EU structural funds and unlikely to be large enough to change the prevailing sense that austerity is not working - countries are ceding growth without any quid pro quo improvement in their finances. Instead, investors are keen to see more significant action either in terms of size or in terms of agreeing more realistic austerity programmes. Official growth assumptions are woefully optimistic and, while a focus on boosting underlying growth is helpful, an extension of the timeframes of austerity programmes is also required. The summit is also likely to have a headstart on the thorny issue of a financial transaction tax. This was discussed at the 22 June mini-summit and, although agreement among all 27 EU nations was out of reach, there were at least nine member states willing to sign up, the minimum required to kick off preparatory work on the legislatory process. So we can expect a dotting of "i's and crossing of "t's on this later this week. There is less certainty about what progress will be made on the more difficult topics of financial stability and European integration. Progress on a permanent rescue mechanism has been painfully slow with the €500 bn European Stability Mechanism (ESM) likely to be delayed beyond its scheduled 1 July appearance. More importantly, there still appears to be a significant division between France and Germany on the possibility of extending the firepower of the ESM, say to buy bonds in the secondary market or inject capital into banks directly. France remains a proponent of granting a banking licence to the ESM so that it may access additional ECB liquidity. However, Germany is nervous about agreeing an open-ended structure, and providing any hints that it might be willing to give ground on debt mutualisation - something they have guarded against in case it is interpreted as a step on the way to eurobonds. The eurobond issue remains an albatross around European politicians" necks despite the refusal of Germany to consider the proposition. Understandably, they remain most concerned about the transfer of fiscal sovereignty - more specifically, Germany being forced to accept liabilities without control. However, for investors the recent Spanish rescue has meant an even more pressing need to cut the dangerous link between sovereign credit and the banking system, requiring a eurozone wide solution. Of course, there is a balancing act to be played here as any form of fiscal transfer would take the pressure off governments to reform and may place the region on an even more unsustainable path - this is clearly behind the resistance to eurobonds in several countries. Global investors would be reassured if some progress could be made. The most rapid path to common issuance would be eurobills, short dated borrowing. However, at some stage there is a need for the largest eurozone members to bite the bullet and decide on a framework to ensure greater fiscal integration. If eurobonds are ruled out, another approach to tackle the corrosive relationship between sovereign credit and the financial sector is banking union, another topic to watch this week. The European Commission has proposed a three-pillar approach based on a deposit guarantee scheme; bank categorisation between systematically important versus smaller national banks; and supervisory and regulatory control. All of these pillars are highly controversial, so expectations for rapid progress are low this week. However, investors will be keen to see any signs that a Europe-wide solution is feasible, for example, whether deposits should be covered by a national or euro guarantee. Conversely, the question of cross-border fiscal liabilities may again be a stumbling block. In the meantime, there are pressing concerns about the need to recapitalise Europe's banking sector and the potential costs associated with such action. Spain has already requested €100bn to inject into its banks, above the €40bn recapitalisation cost estimated by the IMF and the €51-62bn number calculated by two independent auditors. The total banking needs of the eurozone are estimated at closer to €250bn. Clearly, these figures are beyond the reach of the ESM, because its €500bn lending capacity would be seriously eroded should it recapitalise banks in this way. As a result, investors will be looking for a coordinated effort from member states to support their financial system, along the lines of the 2009 initiatives. Those countries and banks that can recapitalise themselves will do so, and those that cannot may be in a position to ask for ESM funds. Investors are not expecting miracle Ballesteros-type golf shots from the forthcoming EU Summit. The best that might be hoped for is a series of good decisions that begin to steer the euro-zone away from crisis. However, as Jean van de Velde, golf's most tragic victim because of his dramatic Open loss in 1999, could testify, even when victory is within your grasp, one wrong choice can steal it away. Andrew Milligan is head of global strategy at Standard life Investments