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From the experts - Europe

Michael Bell

The bigger picture

Far from being a disappointment, the ECB’s latest measures represent a significant loosening of policy that go well beyond what investors might have predicted at the start of 2015, argues Michael Bell, a global market strategist at J. P. Morgan Asset Management
    
Mario Draghi, the European Central Bank (ECB) president, has previously proved a master of expectation management – raising market hopes of policy action only later to exceed them. But sooner or later he was bound to disappoint and Thursday 3 December was that day.

Markets were underwhelmed by the latest policy actions of the ECB’s Governing Council, even though they included both a cut in the deposit rate and a six-month extension of the programme of sovereign bond purchases, also known as quantitative easing (QE).

"It is probably unwise to read too much into the initial market reaction to the decision, which will have been distorted by profit-taking."

Over time, however, we believe investors will get past the talk of missed expectations and focus on the big picture. The reality is this is a significant loosening of policy, which goes well beyond what investors might have predicted at the start of 2015 and should be moderately supportive for eurozone risk assets going forward. It should also prevent the euro from rallying too far, despite its initial reaction.

The measures announced by Draghi included:

* A 0.1% reduction in the official deposit rate, to -0.3%. Draghi had previously suggested that -0.1% and then -0.2% was the “lower bound” for this rate. In the press conference, however, he would not be drawn on whether -0.3% represented a new floor.

* A six-month extension in the minimum length of the QE programme. The ECB had previously committed to purchase €60bn (£43bn) a month until at least September 2016. This pledge has now been extended to March 2017, with the potential for more purchases beyond that date, if necessary. This implies an additional €360bn in bond purchases – or the equivalent of around 3.5% of eurozone GDP.

* A decision to reinvest maturing principal payments on purchased debt, to prevent any future drag on the size of the ECB’s balance sheet.

* An expansion in the range of bonds eligible for purchase under QE, to include regional and local government bonds. This should be particularly helpful in the German market, where the supply of eligible bonds has been an ongoing concern.

So why were markets underwhelmed? Eurozone equities fell by about 3% on the day and eurozone government bond yields rose following the announcement. It is, however, probably unwise to read too much into the initial market reaction to the decision, which will have been distorted by profit-taking. This may be particularly true of moves in the currency, which ended the day up more than 2% against the dollar.

It is fair to say the 0.1% reduction in the deposit rate was at the lower end of market expectations. The other key area of disappointment was the lack of change in the monthly size of bond purchases, despite previous hints from Draghi this could rise. But it is worth noting the US Federal Reserve, in its own QE programmes, did not expand the pace of its bond purchases either.

When asked why he had not done more, Draghi replied that the ECB is confident these measures will be enough to achieve its target given a gradual economic recovery is underway, driven mostly by consumption. He also emphasised the ECB could and would do even more in the future, if necessary, and spoke about the inflation risks being still on the downside. This suggests the policy bias will continue to be in an easing direction, with the potential for more loosening in 2016 if inflation continues to fall short.

Why loosen policy?

The eurozone economy is not doing badly, with falling unemployment and rising consumer confidence supporting a domestic recovery. Lower borrowing costs and increasing bank lending are also supporting the recovery, while the weak euro will support eurozone exporters. The ECB’s growth forecast for 2016 is 1.7%, although policymakers note there are downside risks for the eurozone economy – in particular from emerging market weakness.

Given this reasonably positive backdrop, some have questioned the need for further stimulus. Indeed, this may explain why the decisions in the Governing Council were not unanimous, according to Draghi. However, inflation continues to be well below target – and is expected to remain so for several years – with the new official forecasts announced suggesting inflation will be even lower than previously predicted.

The longer the delay in returning inflation to close to 2% from its current level of 0.1% (or 0.9% excluding food and energy), the greater the risk the ECB’s long-term credibility will be undermined and there will be a further fall in eurozone inflation expectations. That, in turn, would make the target even more difficult to hit, and lead to an undesirable tightening of monetary policy in real terms. After all, it is the real interest rate that firms and households should consider when making borrowing and investment decisions.

While the falling jobless rate is good for the economy, eurozone unemployment remains high at 10.7% and will need to fall rapidly to much lower levels before it starts to generate the wage growth that will ultimately be required to produce sustainable inflation near to target. So the ECB is doing more to try to boost growth and bring unemployment down faster – ultimately to generate wage-driven inflation.

Investor implications

We do not believe the currency movements that followed the announcement mark the start of a prolonged upward move against the dollar for the euro, which – despite the initial rise – remains weaker than at the time of the October press conference. Had the ECB not acted, the currency would surely have risen a lot further, given that expectations for further stimulus had been set so high.

Draghi did not do enough to positively surprise markets and further weaken the euro. But arguably that would have been extremely difficult. In fact, it is fairly unusual for currencies to weaken further in response to policy announcements of this kind. A large part of the move often happens in anticipation.

Despite the initial mild disappointment, we expect eurozone equities to remain well supported by the ongoing and extended QE and improving earnings. Given the Fed is likely to raise interest rates at its December meeting, the stark divergence in the monetary policy paths of the US and Europe could also lead to more euro weakness, despite the initial rally. We would also expect the ongoing asset purchases and continued economic recovery to provide a supportive backdrop for eurozone high yield credit.

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