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The ECB’s Quantitative Easing measures to benefit Eurozone assets

The essential

The ECB’s QE plans have gained the upper hand against the geopolitical tension affecting the eurozone. While the risk of deflation has risen, the response to this risk has paradoxically been very encouraging. On the monetary policy front, the ECB has shown its readiness to significantly expand its balance sheet if needed, a stance that serves to weaken the euro. On the political front, momentum is building. For the first time, the European authorities seem to agree on taking measures to stimulate demand.

In the United States, interest rates remain low despite the end of bond purchases by the Fed, proving that monetary factors alone do not determine long-term rates. With the weakening of potential growth (in both the advanced and emerging economies), equilibrium interest rates also weaken. This serves to raise the equilibrium level of other assets, all other things remaining equal. On the equity side, equilibrium P/E ratios are probably higher than the averages for the past 30 years would suggest.

Against this backdrop, investor appetite for risky assets should remain in place (equity, credit, emerging debt). In the short term, the regions that will see their currencies depreciate, and which remain discounted, still offer some potential (eurozone, Japan). That being said, investors must also understand that the structural weakening of growth should in future be accompanied by structurally weaker financial returns.

The Russia-Ukraine conflict: European markets briefly shaken 

The deterioration of the geopolitical situation in Ukraine, occurring just as German economic figures were beginning to show worrying signs, was the straw that broke the camel’s back in August. The European market had been on a rise since the first announcements by Mario Draghi in July 2012, but without corresponding growth in profits—12-month P/E ratios, which had risen from 8 to 14 over the period, left no more room for bad news. This episode of risk aversion had the effect of lowering long-term interest rates all around the world and raising the value of the US dollar.

In the United States, the weakening of long-term rates and the drop in the price of oil, both favourable to growth, combined with the rise of the dollar, helping to cool inflation, gave further credence that the US economy is in a «sweet spot». The corporate earnings season was also favourable, with analysts raising their 2014 growth forecasts by 0.2% to +6.6%. The fact that the US market is soaring at historical highs only bolstered this confidence. Capital remained with the equity markets; the most volatile capital migrated from Europe to Japan and especially to the emerging markets. Then, on 8 August, European markets began a rebound; the main picture has remained the same: global growth, although revised downwards, remains above 3%, a level compatible with positive profit growth in Europe.

This episode will remain a marking point for asset allocation. Geopolitical factors ultimately helped push up the US dollar; with monetary policy diverging between the United States and other regions (the eurozone, Japan and the emerging countries), this trend should continue.

QE: ECB takes over where the Fed left off

The ECB has just announced a major asset purchasing programme financed by money creation. These quantitative easing (QE) measures will be very different from the ECB’s refinancing operations. Starting in October, the ECB will acquire a wide range of asset-backed securities (ABS). The specific terms of this programme will be known on 2 October. The securities targeted will not be limited to those backed by loans to SMEs; real estate loans (RMBS) are also involved. This will result in a very large expansion in the ECB’s balance sheet, which could easily climb to €500 billion (the eurozone’s securitisation market is valued at approximately €1.4 trillion), on top of the increase from the upcoming TLTROs (17 September and 11 December). Overall, the ECB’s balance sheet could expand by over €1 trillion.

This clearly amounts to a strategic change on the part of the ECB, which has also indicated that (1) inflation risks remain on the downside; and (2) the members of the Monetary Policy Committee unanimously support taking further measures if deflationary pressure persists. The ECB is thus leaving the door wide open to purchases of sovereign debt. The ECB’s “firepower” is considerable when comparing its balance sheet to that of the Fed, the Bank of England and the Bank of Japan. Indeed, the ECB still has ample room for manoeuvre, as its outright purchases of securities are vastly different in scale to those conducted by the other major central banks: the ECB’s purchases amount to only 2% of Eurozone GDP, compared to 24% of US GDP for the Fed, 27% for the Bank of England and 45% for the Bank of Japan.

Meanwhile, in the United States, QE is drawing to a close. The Fed will end its Treasury purchases in October and is preparing to raise its key rates in 2015. The exact timing of US monetary policy will depend on the strength of the recovery in the job market. Unlike in the eurozone, US monetary policy is gradually shifting from «forward guidance» to a more traditional, «data-dependent» approach.

Consequently, 2015 and 2016 are unlikely to see a normalisation in the global monetary base. The monetary base should continue to expand more quickly than GDP, particularly in the developed economies (new easing measures are also anticipated in Japan).

Empirical studies show that QE (as conducted in the US and UK) had a noticeable impact on asset prices and, by extension, on economic activity. In periods of accelerated deleveraging, the objective of the central banks was to stop large-scale balance sheet recessions from creating deflationary spirals by «reflating» financial and real assets (which had been significantly discounted).

 Several transmission channels through which QEs impact asset prices: a signal effect, a stock effect and a market liquidity effect

A signal effect occurs when the central bank announces its intentions. The simple act of announcing an asset purchasing programme changes the anticipations of traders and investors, not only with respect to the direction of future short-term rates but also—and crucially—as to the future availability of (public or private) securities. The actual purchase of securities on the market is the second event. By purchasing an asset (a government bond, for example), the central bank reduces the supply available to the private sector. If the appetite (ex ante) for such assets is unchanged, this immediately weighs down on long-term interest rates (i.e. by raising the price of the purchased asset). Furthermore, if agents anticipate lower yields for the securities to be purchased by the central bank, they will be naturally led to change the allocation of their portfolios. Investors pushed out of this market will fall back on other asset classes deemed to have more attractive valuation, especially since the central bank’s forward guidance offers an implicit guarantee of stable interest rates—this in addition to the favourable impact on market liquidity. Market players show less hesitation to purchase certain securities if they are convinced they will be able to re-sell easily.In the case of the ECB’s asset purchasing programme, market liquidity will have to be restored for asset-backed securities. The development of simple and transparent securitisation in the eurozone should gradually whet the appetite of private investors and allow some banks (particularly in the South) to relieve their balance sheets. The reduction will probably be very significant in Spain, with its large volume of real estate loans.

That being said, the ECB’s QE programme will take place in a markedly different market context than previous examples of QE. When the Fed and Bank of England conducted their QE programmes, risky assets were highly discounted. As such, the pursuit of macroeconomic stability went hand in hand with the steps toward financial stability. Today, this is no longer the case. The ECB’s QE programme comes at a time when the valuation of equities for example is higher than when the Fed initiated its various versions of QE. Therefore, the impact on asset prices will probably be smaller.

Furthermore, the ECB’s QE will have weaker macroeconomic effects domestically than the US example. The wealth effects generated by the increased value of property assets and stocks are weaker in the eurozone than in the US (or the UK). And while the fall of the euro may give a boost to exporters at just the right moment, the final impact on growth should not be overestimated. The rise in the price of imports—energy products in particular—would diminish this impact.

The eurozone is shifting toward a more accommodative policy mix. The ABS-based QE measures announced by the ECB are unlikely to contain deflationary pressure. National governments, the ECB and the European Commission have taken note of this. As Mario Draghi said at Jackson Hole: “The only way back to higher employment… is a policy mix that combines monetary, fiscal and structural measures at the union level and at the national level.” Draghi’s position is not far from that of Jean-Claude Juncker, who has expressed support for a major, €300 billion investment plan in the form of a public-private partnership aimed at stimulating youth employment and growth over the next three years. Nor does it diverge from the stance of Bundesbank President Jens Weidmann, who has argued in favour of wage increases in Germany.

At the end, the eurozone stands to benefit from a series of favourable factors:

  1. large-scale QE by the ECB (which is only in its infancy and could be expanded to sovereign debt, if needed);
  2. interest rates that are not ready to rise;
  3. a weakening of the euro, which should continue;
  4. a potential European recovery plan based on infrastructure investment (the «Juncker Plan»);
  5. an easing of lending conditions;
  6. budgetary policies that are less restrictive than in recent years (governments will let automatic stabilisers fully work); 
  7. a recovery in the peripheral economies most deeply affected by the crisis (Spain, Portugal, Greece and Ireland).

Against the backdrop of a persistently supportive global growth environment, these factors will work in favour of the continued defragmentation, both economic and financial, of the eurozone.

 

Structurally weaker interest rates mean higher equilibrium prices on risky assets

Monetary policy alone does not explain the weakness of long-term interest rates. The clearest proof of this comes from the United States, where despite the tapering of bond purchases by the Fed (QE3) and the positive growth momentum, long-term interest rates are not rising; indeed, over the past 12 months they have fallen. In the eurozone, long-term bond yields have fallen with the rise of deflationary pressure despite the reduction in the ECB’s balance sheet.

The explanation for the low interest rates is also to be found in the real economy. Here, we can observe some elements of «secular stagnation», a structural slowdown of growth linked to supply-side factors, such as the ageing of the population (leading to lower labour force growth) and the weakening of productivity gains due to a slowdown in innovation. These trends can be observed in the major developed economies, including the United States, but also in some emerging countries such as China, where potential growth is slowing. Indeed, it is increasingly difficult to distinguish what is the result of the economic environment (i.e. demand factors) from what is attributable to structural changes (i.e. supply factors).

With the weakening of potential growth, equilibrium interest rates also weaken. The impacts on the equilibrium values of other assets are unclear. With equities, for example, this means that future profits will fall as a consequence of lower growth. In contrast, a fall in the equilibrium of long-term interest rates would result in the parallel increase in the equilibrium of multiples (P/E ratios).

This global growth environment, with weak inflation and still-abundant liquidity, leads us to make four conclusions:

  • We remain positive on risky assets, starting with equities.
  • On the fixed-income markets, we are maintaining our position in Investment Grade credit, High Yield credit, bonds from the Europeanperiphery countries and emerging country debt. 
  • Low real interest rates justify the higher equilibriums of risk premiums compared to historical averages (see Box 2). Thus, as long as current circumstances prevail, a swift decline in risk premiums should not be expected; however, risk premiums will not stop the markets from rising in the meantime.
  • Expected returns on the equity markets will fall more and more in line with profit trends, which in turn will depend, in the short term, on the evolution of exchange rates. This means that investors seeking to profit from the rise of an international market should hedge their positions if they do not wish to lose what they gain on the equity markets (in local currency) to foreign exchange fluctuations, particularly in the case of the eurozone and Japanese markets. Given our foreign exchange previsions (EUR/USD at 1.20 within one year), this does not apply to the US market. After the warning on the European markets, investors will now set their sights on the United States. The US mid-term elections in early November will coincide with the end of QE and more visible signs of improvement on the employment front. All of this will complicate the Fed’s communication efforts for the rest of the year. The continued rise in equity markets that we expect to see will not be a long, smooth journey.

The ECB has adequate means to conduct asset purchases

 

0-1

 

Long-term interest rates are unlikely to rise in the near future in the eurozone

 

0-02

 

The equilibrium price of risky assets is higher than historical averages

 

0-03

 

The US dollar will continue to rise against the euro and yen

 

0-04

 

0-05

PORTFOLIO TYPE

Equity portfolios

Bond portfolios

Diversified portfolios

  • Prefer eurozone equities
  • Stay overweight on Japanese equities
  • Stay neutral to overweight US
  • Beta of portfolio maintained to neutral
  • Emerging markets: country selection is key
  • Within emerging markets
    - stay overweight Gulf States, Mexico, Brazil,
    India, Thailand and Greece
    - neutral China, Turkey, South Korea, Russia
    - stay underweight South Africa, Malaysia,
    Taiwan and Chili
  • Prefer industrials to consumer goods
  • Maintain long USD, short JPY and EUR
  • Maintain overweight position especially on European HY
  • Maintain overweight position on Italy and Spain
  • Maintain underweight/absent from peripheral countries having liquidity – solvency issues
  • Long duration on core eurozone
  • Overweight emerging debt
  • Remain selective on financial securities
  • Maintain Long USD and GBP, short JPY and EUR
  • Stay neutral US equities
  • Prefer eurozone equities
  • Overweight on EMG equities
  • Maintain long position on corporate bonds
  • Overweight position on sovereign bonds of peripheral Eurozone countries
  • Positive on emerging debt
  • Maintain Long USD, short EUR

 

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Didier BOROWSKI, Head of Macro Economics
Eric MIJOT, Strategy and Economic Research at Amundi
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The ECB’s Quantitative Easing measures to benefit Eurozone assets
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