Last week's market action confirmed the ongoing importance of global monetary policy as a theme on our Macro Radar. After being down 2.45% mid-week, global equities (as measured by the MSCI All-Country World ETF: ACWI) rebounded 4.50% to finish the week in the black by just over 2%. The directional reversal came complements of European Central Bank President Mario Draghi when he said the following in a speech delivered at an investor conference in London:
Within our mandate, the ECB is prepared to do whatever it takes to preserve the euro. And believe me, it will be enough.
A lot has been made of this simple statement over the past five days, confirming once again that we remain in a policy-driven market environment.
A potential inflection point?
It has long been debated to what extent the ECB will be willing (or even legally capable) of engaging in outright bond purchases of Eurozone countries' sovereign debt. Such programs have already been implemented throughout this crisis, but such efforts have been limited and have fallen short of anything akin to the US Fed's quantitative easing programs in which they "print" additional money for the purpose of purchasing Treasury bonds on the open market. Draghi's comments last week are clearly being interpreted by the market that the ECB is on the verge of taking their bond purchasing to another level.
Why would the ECB be considering this, and what difference will it make? The chart below tells the story. Since the beginning of the European crisis there has been a growing divergence between 10-year yields on US and Spanish debt. Remember, Spain is struggling with the negative feedback loop of economic recession, diminished tax revenue, gaping fiscal deficits, bloated debt levels and higher refinancing costs. If you think logically through this progression you'll notice that each problem leads to the next in a self-reinforcing cycle.
What separates the US from Spain in this instance is that the US can at least still borrow money in the open market - and do so at incredibly cheap rates. The existence of record low interest rates (complements of the Federal Reserve and the favored status of the US Dollar as the world's reserve currency) means that the debt service burden is far more manageable in the US than it is in Spain. This is the motivating factor for Draghi and the ECB to consider more direct bond purchases. By bolstering demand for peripheral sovereign debt they would hope to push long-term rates lower and alleviate the pressure from at least one of the links in the feedback loop described above. While this would, indeed, extend the timeline for certain negative outcomes from this crisis, it does nothing to address the more structural issues at play.
Furthermore, there are clear hurdles to the ECB implementing outright bond purchases in large scale. Germany has historically been reticent to endorse this action without more political and fiscal cooperation from the peripheral countries struggling to trim deficits and debt. Just this weekend German finance minister Wolfgang Schaeuble made the following statement:
The high interest rates are painful and they create a lot of concern - but it's not the end of the world if one has to pay a few percent more at a few bond auctions.
Despite these hurdles, Draghi's recent comments appear to be calculated and premeditated, and it is unlikely that he would have hinted at additional policy stimulus without consensus amongst the decision makers that will be responsible for making it happen. Thus, we would expect some amount of follow up to come out of the ECB meeting this Thursday, but whether or not it fulfills the hopes and expectations of a market eager for more stimulus remains to be seen.
How should we respond?
We remain underweight in risk assets across the board in our client portfolios. This positioning is driven primarily by our quantitative risk management program, MarketVANE, but is also influenced by our macro convictions - particularly our anticipation of changes in global monetary policy. Given this defensive position, we are currently at risk of not fully participating in any relief rally that may ensue on the back of aggressive new policy announcements from the ECB this week. That said, a number of our quantitative signals are in the process of, or close to, turning bullish again, and our current positions in gold (GLD), gold mining stocks (GDX) and emerging markets (CAF, FXI, RSX) would likely benefit more than the broader market should central bank policy be the tailwind pushing risk assets higher.
Additional disclosure: Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.