X-Factor Report, 26 January 2015
by Lance Roberts, StreetTalk Live
This past week, after two years of “jawboning the world to death,” the European Central Bank (ECB) launched their version of quantitative easing or QE.
Let’s walk through the program and take a look at the most important aspects of what the ECB just did. From Societe Generale:
A) The size of QE program is €60bn per month, €1140bn in total
The main measure is an expandable asset purchase program that includes European agencies and sovereign and complement the current programs (Covered bond and ABS purchase programs). Those new programs will start in March 2015 and run until end September-16 or until the inflation outlook converges to 2.0% medium-term, which means that it could be bigger. The combined purchases will amount to €60bn per month. Apparently, the expanded program will not include corporate bonds.
The ECB will purchase €1140bn (60*19) from March 15 to September 2016. Today, the pace of covered bond and ABS purchases is close to €13bn per month, so additional purchases represent €47bn per month.(Note: The Federal Reserve was doing $85 billion per month during QE3)
The ECB stated that “purchases of securities of European institutions will be 12% of the additional asset purchases”. A quick rule of thumb suggests €230bn in ABS and covered bonds, €110bn in European agencies and €800bn of sovereign bonds.
The ECB also decided to cut the spread on the TLTRO rate, which would now be equal to the refinancing rate (0.05% instead of 0.15%)
B) Criteria to be specified in March
We know that the new programs are running until September-2016 at least and that purchased bonds will be held up to maturity. Obviously, purchases will be made on the secondary market for European issues and government bonds.
In terms of rating, it is likely that the conditions will be the same as for the ABSPP and CBPP3. First, the ECB will purchase investment grade bonds.
Secondly, for Greece and Cyprus (which are not investment grade), the condition would be that those countries “have an ongoing program with the EU/IMF”. This would suggest that any failure to extend the current Greek program that expires at the end of February would exclude Greece from any asset purchase program.
Can the ECB buy at negative yield? Yes, said Draghi during the press conference
Which maturity? Details will have to be specified in March but Draghi suggested that maturities could be of 2-30 years.
Interestingly, Draghi said that it will have two limits on its purchases: 30% of the issuer outstanding and 25% of the issue. This latter limit will prevent the ECB of having a blocking minority in CACs, with the aim “to ensure that the ECB is pari passu”. As we argue below, this is not convincing, given the low degree of risk sharing.
C) Minimum symbolic risk sharing (8% risk sharing only on government bonds)
The main piece of information in the ECB communiqué is here:
“With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing”.
So the ECB indicates that the degree of risk -sharing is 20%, which seems a good compromise. However, regarding government bonds, the degree of risk sharing seems symbolic (8/100-12=1/11). To put is simply, the ECB will purchase €70bn on a risk sharing basis while the NCB will purchase the remaining €730bn.
This approach is consistent with our long held view that the ECB QE could not be both large and pari passu. Legal and political hurdles remain large because of the two articles of the European Treaty: Article 123 on prohibition of monetary financing and Article 125 (no bailout clause or no mutualization clause).
The ECB might well be pari-passu ex ante as Draghi argues. Yet, in the case of a debt restructuring, either the CB would avoid the debt restructuring (remind that the Eurosystem avoided the Greek PSI in 2012) or the (bankrupt) national government would probably be obliged to recapitalize its NCB. In both cases, the bigger the purchases are, the larger is the expected loss given default of the private sector. Hence the final outcome on sovereign bond spreads might be uncertain as debt sustainability concerns increase in the future. The flow of purchases will be positive but lower liquidity and higher expected loss given default will play out negatively.
Will It Work?
Of course, the real question that needs to be answered is whether or not it will actually lead to higher levels of inflation, employment, and economic growth? The charts below show the current landscape in the Eurozone.
With unemployment remaining extremely elevated, inflationary pressures plunging, and economic growth waning, you can see why the ECB has become desperate to “do something” to try and reverse the tide. However, while it is certainly hoped that the ECB can spark inflation and better economic growth with the current QE program, there is little evidence that it actually worked in either Japan or the U.S. The chart below shows the economic growth of Japan, the U.S. and the Eurozone overlaid.
Importantly, there has never been a period where the U.S. economy remained detached when the Eurozone and Japan were both flirting with recession. The U.S. will likely have very tough sledding over the quarters ahead unless the rest of the world can start to gain momentum.
As I discussed last week, Central Bank’s monetary policy tools have little effect on reversing deflationary trends either. After successive bond buying programs in the U.S. and Japan, there has been little impact on inflation.
The current weight of evidence suggests that the ECB will likely come up far short of its goals.
Will The ECB’s QE Program Be Enough
There is also a crucial difference between the U.S. and the ECB. As opposed to the U.S., the ECB currently offers a “negative deposit rate.” This means that the banks selling bonds to the ECB will lose money on the interest carry. At least the QE programs in other countries allowed banks to earn some interest on their excess cash. At the ECB, sellers will have to pay the ECB to in order to hold excess cash. This could impede some of the success of the ECB’s QE program as banks potentially think twice before selling.
Societe Generale concluded with an excellent diagnosis:
We argue that the ECB QE could be five times less efficient than in the US. In December, press reports suggested that the ECB had run studies suggesting that a €1000bn QE program would only boost price levels by 0.2-0.8 after two years, five to nine times less efficient than the studies for the US or the UK. The impact on GDP is not provided, but it would be reasonable to assume the same impact as on inflation on a cumulated basis. These figures are consistent with our own estimates.
The potential amount of QE needed is €2-3 trillion! Hence for inflation to reach close to a 2.0% threshold medium term, the potential amount of asset purchases needed is €2-3tn, not a mere €1tn. Should the ECB target such an expansion of its balance sheet, it would have to ease some conditions on its bond purchases (liquidity rule, quality…) or contemplate other asset classes- equity stocks, Real Estate Investment Trust-(REIT), Exchange-traded fund (ETF)…- as the BoJ, previously.
So the onus will remain on delivery of better-designed fiscal policy and structural reform. But it is difficult to be hopeful on these fronts.
Should I Invest In European Stocks
From a technical perspective, it is not yet time to buy European stocks. As shown below, domestic stocks are still clearly outperforming their European counterparts. More importantly, European stocks are on a major “sell signal” currently AND remain confined to the current downtrend. While there has been some improvement in performance in recent weeks it is worth waiting until a break of the downtrend occurs and confirms that a new buying opportunity has indeed occurred.
However, from a fundamental perspective it is worth noting that the collapse in the Euro, as compared to the U.S. dollar, will likely weigh heavily on both exports and corporate profitability in the quarters ahead. Michael Kahn wrote a similar note in Barron’s this past week:
“But the falling euro, and commensurate soaring U.S. dollar, will be a problem for American exporters. By extension that suggests large-capitalization stocks, which do a large percentage of their business overseas, are facing some troubles.
The attractiveness of U.S. stocks, which were by far the best place in the world to put money to work this decade, has waned, at least in the near term.”
For this reason, it is prudent to begin reducing overweight exposure in domestic equities that have a high degree of international exposure, particularly to the Eurozone area.
I will cover more on this issue in the Sector Analysis section below, but the bottom line is remain cautious for now.
Have a great week.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at the bottom of this report.