Could A Potential ECB Surprise Support European Stocks Next Week?

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Includes: DBGR, DXGE, HEWG
by: Batur Asmazoglu

Summary

Last year the ECB disappointed markets which led to lower European equity valuations.

This year the ECB's inflation assumptions and positive outlook must have taken a hit.

Oil could drive their inflation models to the ground. Is it time for action?

European stocks are lower a second day as oil prices drop and credit fears grip the globe. In Stoxx Europe, commodity producers group posted the largest drop in 19 groups, but the whole index has pushed lower to a technically bearish channel, and during the earnings season, it seems weakness will persist.

In the last week of December, the European Central Bank stopped its 60 billion EUR asset purchase target, halting purchases in December during the holiday season. Public and private sector debt holdings of the bank climbed by 50 billion EUR last month, according to the public ECB data. The bulk of it, almost 90%, of course, was public debt. The suspension between 22nd of December and 1st of January created a shortfall of around 10 billion EUR compared to November.

The DAX, which has dropped by as much as 12% from November peak, is underpinned by a multi-year trend line; the beginning of the slide coincided with disappointment over ECB policy as Draghi refrained from expanding QE. Coincidence here is probably not the right term as the same disappointment also led to EUR strength, which is one of the problems haunting the European Central Bank. Slump in oil prices, China concerns and risk aversion continue to cloud the ECB's inflation outlook, although euro-area activity indicators show signs of green shoots. Most analysts expect Draghi to repeat ECB remains willing and able to act, but won't be in any rush to do so at the January meeting. It is true the ECB seldom reacts to market volatility unless it's prolonged or has clear effects on real economy and business confidence.

Most analysts agree December ECB minutes mean no new measures will be announced next week but in terms of oil and inflation expectations the market has moved quite a bit. I believe there is some chance, albeit small, he might come up with further easing in this meeting. As I said, most analysts would not agree with this but they do expect him to pave the way for more easing in spring. Euribor implied are slightly lower today with the fix at a week low. If the ECB is pushed into the corner to come up with further dovish signals and action, DAX may get a boost here renewed by action against Euro area disinflation. The recent risk off mood and EUR's relative strength have led to an increase in expectations of a 10 bps rate cut in March from 23% to 54% in the last five days.

If the ECB acts with more conviction, this would be a relative surprise to the market. Last year's crowded ECB and European stocks trades have mostly been exited so positioning would prove to be supportive as well. Best bet would be to go long DAX during the EUR weakness that would follow ECB action. Best ETFs would be ones that avoid the commodity links, but more importantly, ones that are currency hedged so one would not suffer from EUR weakness, the iShares Currency Hedged MSCI Germany ETF (NYSEARCA:HEWG), the WisdomTree Germany Hedged Equity ETF (NASDAQ:DXGE) and the Deutsche X-trackers MSCI Germany Hedged Equity ETF (NYSEARCA:DBGR).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.