During the summer of 2012, at the height of the European sovereign debt crisis, Mario Draghi announced to global financial markets that the European Central Bank (ECB) was "ready to do whatever it takes" to preserve the single currency and fight excessive borrowing costs. This was a tall order at that time, considering how dire the budget deficit and debt-to-GDP levels were for the majority of the eurozone members.
At the same time, the European equity markets bottomed and resumed a very modest uptrend, ending the bear-market decline that had started a year earlier. On numerous occasions since uttering those words, during periods of geopolitical unrest and economic uncertainty, Mario Draghi repeated some variation of that phrase, and quite remarkably was successful in continuing to talk down government borrowing costs and stem any decline in equity markets. It is clear, however, that his oratory skills have limitations that money printing does not, as the US and Japanese equity market performance has significantly surpassed that of Europe. Notice that the US equity market, denoted in the chart below by the S&P 500 index (NYSEARCA:SPY), decoupled from European equities to significantly outperform under the influence of the Federal Reserve's multiple quantitative easing (QE) programs.
By the same measure, Japan's stock market, denoted in the chart below by the Nikkei 225 index, was tracking the performance of European equity markets prior to the announcement in early 2013 that the Bank of Japan would be doubling the country's money supply with a massive QE program worth $1.4 trillion. Japan's stock market surged higher in response.
Despite the collapse in bond yields, budget deficits remain unsustainable, given that seven of the eurozone's 18 members are expected to have debt-to-GDP levels in excess of 100% for 2015.
There has been very little progress in achieving sustainable economic growth or the ECB's target of just under a 2% rate of inflation. At the core of the stagnation is a still staggeringly high unemployment rate that peaked at 12% in February 2013.
Given this macroeconomic backdrop, it is not surprising that the ECB is now embarking on its own quantitative easing program. With everything it has done to date having had little impact, in order to uphold its commitment to do "whatever it takes," there is nothing left in its arsenal except a QE program.
The ECB and national central banks of each eurozone country will collectively purchase approximately $68 billion per month of what is predominately sovereign debt, beginning in March and continuing until the end of September 2016. The purchases will total approximately $1.14 trillion, and they will be in proportion to the size of each member country, as can be seen below.
There are a number of other distinctions between this QE program and the ones implemented in the US and Japan, as well as the QE program implemented by the Bank of England. The ECB will only be responsible for 20% of the total purchases, so should losses occur, the national central banks will suffer the majority of the losses. Each national central bank will be limited to purchasing its own government bonds. No more than 33% of any country's outstanding bonds will be purchased, which means that smaller countries with less debt outstanding will be eliminated from the program much sooner than the larger ones. Stealing a page from the Bernanke playbook, the program will be open-ended, meaning that if the ECB is not approaching its 2% inflation target by the end of the program, the purchases could continue.
According to Mario Draghi, this program "should strengthen demand, increase capacity utilization and support money and credit growth." The ECB and various central banks will be buying bonds from banks with newly created money. The banks will then be able to use these newly created bank reserves to extend additional credit to households and businesses. That in turn can lead to an increase in consumer spending and further stimulate economic growth.
What It Will Accomplish
The ECB's QE program will put further downward pressure on sovereign bond yields, but only to a limited extent, considering how far yields have fallen recently in anticipation of the program. German 10-year bunds yield a paltry .36%, while the 10-year in France, Spain and Italy yield a respective .54%, 1.37% and 1.52%. This makes the US 10-year Treasury initially look far more attractive at 1.79%, except that with the inflation rate in the eurozone falling into negative territory (deflation) in December 2014, compared to a rate of inflation of 1.6% in the US for 2014, the eurozone still has higher real yields.
Lower interest rates in combination with increased liquidity are also likely to translate into rising stock prices in the eurozone, as they did in the US and Japan. When the central banks buy bonds from financial institutions, the proceeds from the sales are then reinvested, and the process repeats itself, often in higher-risk and higher-returning assets with the proceeds from each successive sale. It is certain that this is one of Draghi's objectives, that being to instigate a wealth effect, given what transpired in the US and Japan in terms of stock market performance.
The most immediate and pronounced economic impact from the QE program is the continued decline in the value of the euro. It has already plunged from $1.35 to $1.12 over the past six months, and it is realistic to see it approach parity with the US dollar in 2015.
This is clearly one of the ECB's primary objectives, as a weaker euro will stimulate economic activity through stronger export growth. It will make it more attractive for foreign tourists to visit European vacation destinations. It will also lift consumer price inflation by raising the prices of imported goods for European consumers.
What It Won't Accomplish
While lower sovereign bond yields that result from QE may be helpful in managing unsustainable budget deficits and debt-to-GDP levels, they are likely to be detrimental in terms of allowing national governments to ease back on politically unpopular but desperately needed structural and fiscal reforms. Most Europeans who have jobs and financial security are not interested in changes that may put either at risk, although that is what is necessary to create economic opportunities for the next generation, nearly half of which is unemployed in Spain and Italy. Reforms are an absolute necessity in order to improve productivity. Increased productivity is paramount in improving rates of economic growth when the fertility rates in many European countries are below the replacement rate. The population is shrinking. I do not think QE will help push forward reforms.
QE will not stimulate the demand for loans or the incentive to lend in the eurozone. The majority of European companies obtain their credit through bank loans rather than the bond market, so lower bond yields have far less influence than they do in the US. The banks already have an excess of credit available through the ECB, so they don't require any more liquidity. They are also less likely to extend credit as they continue to deleverage and abide by new regulatory requirements. If they do lend, considering how low interest rates are currently, they are more inclined to lend to the safest borrowers, who are the least likely to stimulate economic growth, as well as the least likely to need the credit.
The demand for credit is an offshoot of economic growth, and the only way to stimulate economic growth is through investment. While QE is likely to stimulate the demand for financial investments, it will not stimulate investment in production. That is the type of investment that will create jobs for the more than 18 million unemployed.
While QE may lead to an increase in the rate of inflation, it will not create the kind of inflation that the ECB is targeting. Importing inflation through a weaker currency is detrimental to consumers without a commensurate rise in wages, and it is devastating for the unemployed and underemployed. Japan is now realizing a significant decline in real wages as a result of the weakening yen, since approximately 50% of its food is imported. The US economy has also suffered from stagnant real wage growth.
While I don't believe that "whatever it takes," which in this case is quantitative easing, will be enough to revive the eurozone economy, I am cognizant of the fact that it has a tendency to revive asset prices. This tendency is particularly strong when there is no loan demand and interest rates are at historically low levels. All of this newly created money will search out the highest rate of return. Corporate earnings for European multinationals are likely to get a significant boost from the currency depreciation. They will also gain market share, particularly in Germany.
Using the QE programs in the US and Japan as precedents, it is my assumption that the European equity markets will respond favorably to QE, narrowing the performance lag we have seen over the past two to three years. Therefore, a broad basket of European equities that is currency hedged should perform well in 2015 if history repeats. The Wisdom Tree Europe Hedged Equity Fund (NYSEARCA:HEDJ) is an ETF that fits this description. I am leery of initiating a position in this ETF at the moment, considering the appreciation we have seen so far this year in anticipation of the ECB's QE program announcement. The market volatility likely to follow the Greek election results may present a better entry point in the weeks to come, prior to the QE program's initial purchases.
Germany stands to benefit more than any other eurozone member both from a weaker euro and the liquidity created by the QE program, considering that it is the lead exporter and has the largest share of ECB capital. As such, the Wisdom Tree Germany Hedged Equity Fund (NASDAQ:DXGE) is well positioned to benefit from the ECB's QE program. Yet I would also look for a pullback in price in this ETF from current levels before initiating a position.
The ugly truth is simply that it takes time to write off bad debts, pay down what debt remains to healthy levels, and allow supply and demand to rebalance as the business cycle expunges the excesses. This process is at varying stages depending on whether we look at the US, the UK, Japan or the eurozone. The jury is still out as to whether quantitative easing is prolonging this process, speeding it up, or leading to an entirely different form of financial crisis down the road. Time will tell, but for the time being, with increasing unknowns, it is prudent to maintain liquidity, stay diversified and shorten time horizons until there is more certainty as to how history will judge the success of this experimental monetary policy. For the record, I am not a believer. Despite being bearish on the eurozone economy and having little faith that QE will be successful in reviving growth, bears can't simply hibernate. They have to look for low-risk opportunities to ride the bull, and in that vein, I am looking to capitalize on "whatever it takes," even if it ultimately does not work.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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