The ECB Has Our Back; What Exactly Does That Mean?
Market insights from the international investment professionals at Euclid Advisors:
“The ECB has our back.” That’s how we’ve framed some of our macro views on cyclically-oriented European stocks, ever since ECB President Mario Draghi proclaimed in July 2012 that he’d do “whatever it takes” to preserve the euro. Now more than two years later, although we still have faith in Mr. Draghi’s intentions, it has become increasingly apparent that Europe’s economic situation is too complicated to characterize this neatly.
Europe’s economy is growing collectively but not very fast, perhaps one half of a percent, on its way to one percent. European manufacturing readings (PMIs) have rolled over but are still above 50. Low inflation and the Russian/Ukraine crisis are not helping matters. Mr. Draghi understands that the European economy is fragile and must continue to be supported by monetary policy. However, the ECB does not have the ability to enact widespread quantitative easing (“QE”) like the Federal Reserve, and must be more nuanced in its approach to the 18-nation euro zone given the varying growth and reform needs of each economy.
So what has Mr. Draghi done for us lately? For one, he has implemented negative interest rates on deposits, requiring member banks to pay the ECB to keep their money, and this should encourage lending into the real economy rather than sitting on cash. He is also introducing targeted longer-term refinancing operations (TLTROs) versus the existing mere LTRO programs. The difference with the TLTROs is that banks must use the proceeds to lend to real businesses – mostly small- and medium-sized entities (SMEs) – rather than obtaining low-cost financing to buy “low risk” sovereign debt and pocketing the spread. The point with this latest refi iteration is to encourage an actual transmission mechanism from the low borrowing rates the ECB offers to the creation of credit in the real economy.
Europe is unlikely to see traditional QE as the world has come to know it, as we’ve seen with the actions of the Fed, the Bank of England, and the Bank of Japan. The Germans won’t stand for it, and the ECB does not want to be seen as financing fiscal deficits. There are also structural problems as the ECB has to buy bonds across several countries, not just one. It is not as though there will never be QE in Europe; it is just that the hurdles are much higher. One QE subset that offers possibilities is the ECB purchases of SME asset-backed securities (ABS). However, this market is not that deep in Europe, the mechanics can be daunting, and the direct transmission to the real economy is not overwhelming as it basically removes the securities from bank balance sheets, while there is no measure to force banks to relend the proceeds into the real European economy.
Central banks move at their own speed. Monetary policy works with a lag. While Mr. Draghi is aware of the lethargic European economy, the low inflation rate, and the economic risks from the Russian/Ukraine crisis, he wants to see if the measures being put in place take hold. Why rush in unnecessarily with more drastic actions such as broad QE which would be more difficult to implement. He also wants to see structural reforms, especially in France and Italy, and he may not want to make a move right in front of the final asset quality review (AQR) coming in mid-October. The banks are trying to put forth the strongest balance sheets they can into that exercise. Why give them cheap money they won’t lend anyway until they have passed that test?
So while it may still be true that “the ECB has our back,” that statement does not convey the inherent complexity of the central bank’s task. Weak GDP readings may get the headlines, but there is much positive work being done behind the scenes to bring Europe to self-supporting growth in the future.