By Christopher Mahon
No one should be surprised by Mario Draghi dropping hints that both quantitative easing and the negative interest rate regime could be extended in December. The truth is that it would be madness to end the monetary stimulus programme within Europe.
In the short term, quantitative easing is the binding agent holding eurozone bond yields down. Without it, for instance, the last four weeks would have seen Portuguese bond yields spike sharply higher given the political uncertainty in Lisbon.
In the medium term, the low / negative interest rate regime is required to prevent the household sector from hoarding cash. For peripheral markets like Spain, this has been vital to force households to re-enter the local property market. Peripheral real estate markets have stopped falling and moved higher, giving a major fillip to confidence and stopping the debt deflation story in its tracks.
And in the long term, both negative interest rates and quantitative easing are required to have a chance of keeping peripheral governments solvent. Avoiding a government debt spiral in peripheral nations, most especially within Italy, is at the top of the agenda.
There are no two ways about it. If Mr Draghi is serious about doing “whatever it takes”, then he will need to prop up the government sector for a long time to come. Indeed we repeat our call that a decade hence overnight rates in euroland will be less than one percent.
Investors should not be surprised to see the European Central Bank (ECB) extend the stimulus programme.
“Kicking the can down the road” might just be a good thing
(so long as you are not a German taxpayer)
The ECB has come under a lot of criticism for “kicking the can down the road” by delaying the day of reckoning for peripheral European countries and their mountains of debt. Quantitative easing, some argue, just delays the inevitable.
This criticism misses the point. At a regional level, the eurozone does not have an excessive debt problem. It has a political problem: how to pass the debt burden from the periphery to the core without too many voters noticing. The ECB may well be kicking the can down the road, but if along that road the principle of debt mutualisation – risk-sharing across European nations – becomes established in a behind the scenes fashion, then the problem might be solved.
Sotto voce debt mutualisation is already developing. The International Monetary Fund and the ECB are pushing for Greek debt owed to the eurozone taxpayer to be “restructured” into interest free varieties. Northern European savers face zero interest rates for many years to help their Southern European brethren. Structural payments and communal infrastructure programmes gush forth from Brussels. The northern Europe central banks lend their credibility to the ECB and take the ultimate liability for the ECB’s quantitative easing programme. However you look at these programmes, the burden of the debt is being spread.
It is inevitable that debt mutualisation will quietly and stealthily come about. It just needs time. Ten years from now, debt mutualisation will have occurred – but it won’t be signposted as such.
Market implications
What does this mean for European assets, particularly equities? Before we bake in the views around quantitative easing and negative interest rates, our starting point for our European market view is our ten year forecast.
Our ten year exercise combines our view on trend GDP growth with a normalised view on profitability and valuation to come up with total return expectations for a variety of asset classes. In the case of European equities, the normalised assumptions we use give a projected return of just over 5% p.a. This is not a great return for taking on equity risk, but in comparison to the paltry returns on offer elsewhere looks quite generous to us.
Of course, the key assumption behind these numbers is that we get back to normal in ten years’ time. However, with negative interest rates to stay in Europe for a long time yet, the risk is that European equity markets actually do better than these numbers. Households, institutions and pensions funds are already being forced to scramble to find positively yielding assets.
For the European investor, we believe cash will be a certain loss. So a 5% prospective return on equities or real estate might look quite appealing. This remorseless logic means today’s fair value on equities could become something more expensive, with valuations grinding upwards.
In this environment, our normalised assumptions will probably look on the conservative side for a while yet. Ultimately, if the ECB is propping up governments, our assessment is that equity markets in Europe will be supported as well.
Christopher Mahon is director of asset allocation research, Baring Multi Asset Group, Baring Asset Management.
Comments