The European Central Bank had no choice but to launch its own quantitative easing programme in the end. The jury is still out on whether it will work – but judging by the first reactions, it could actually mark the return to some sort of normality for the eurozone.
The ECB will buy 60 billion euros ($68 billion) worth of assets per month starting in March, comprising sovereign bonds and bonds issued by various agencies of the EU, covered bonds and asset backed securities. It will do this every month until September 2016 or even later if inflation doesn’t return towards its target of 2% for the longer term.
The euro plunged against the dollar on the news and European stock markets rallied on Thursday.
This means investors were pleasantly surprised by the announcement, despite the fact that there were leaks on Wednesday about the size of the asset purchases which, at 50 billion euros, proved quite accurate.
It also means that ECB President Mario Draghi has managed once again to defend the credibility of the central bank in the face of powerful scepticism, the most vocal of which has perhaps been that of well-known bearish investor Marc Faber.
The fact that the ECB joined the currency war six years after the Federal Reserve and the Bank of England has profound implications for investors.
Since the financial crisis, while other central banks have kept distorting the markets with asset purchases, the ECB had largely abstained from inflating asset prices – so this adjustment may take some getting used to.
What will be the best transmission channel for the ECB’s quantitative easing?
We know that the wealth channel wouldn’t be as effective in the eurozone as it was in other markets. QE works by pushing up the prices of assets such as stocks and bonds, as the central bank acts like the “big gorilla” in the market absorbing big quantities of assets and so creating scarcity.
In the eurozone, however, there are not as many retail investors as there are in the US or even in the UK – so ordinary Germans, French, Spanish or Italians are unlikely to feel richer even if stock prices do go up.
The banking channel is broken, too. Banks’ assets make up around 270% of eurozone GDP, while in the US they amount to only a little more than 70% of GDP. Add to this the burden of regulation, and you can see why banks will not be very happy to exchange their safe sovereign bonds for riskier loans to businesses and individuals in the eurozone.
Euro depreciation is crucial
The only transmission channel that will work is the exchange rate. The euro has lost around 18% to the dollar since early last year and it looks like it will continue to fall.
Analysts at HSBC cut their forecast for the exchange rate following Thursday’s ECB meeting, and now they expect the euro to end the year at 1.09 against the dollar compared with a previous forecast of 1.15.
The euro’s weakness will be good for exporters. German equities will be well positioned to benefit from this, and investors would do well to look at companies in Central and Eastern Europe, too.
Many companies in Poland, Hungary and the Czech Republic make cars or parts for German factories, so they stand to benefit.
French companies could also benefit and this could pull up Romanian equities too, where many big French firms have set up subsidiaries.
Another sector to watch will be that of energy, since it is this month’s best contrarian trade according to a fund manager survey by Bank of America Merrill Lynch.
Quantitative easing in the eurozone could also push up property prices – one development to keep an eye on will be any speculative rotation by foreign investors away from the over-heated London residential market to property markets that are relatively undervalued, such as those of Germany, France or Spain.
And lastly, if inflation does indeed follow, it will have the effect of reducing debt by stealth. A more radical – but deeply unpopular – solution for the eurozone’s crisis would be forgiving household debt outright, but no government is likely to dare to opt for it.
Inflation is the second-best choice and, if the ECB’s quantitative easing works, could help the eurozone get out of the crisis. Unless Greece’s election at the weekend does end up unleashing the perfect storm – in which case, the ECB’s efforts would amount to very little.