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Marcuard's Market update by GaveKal Research
What are European investors hoping for? Or, to put the question more forcefully (and give away our conclusion) what have they been smoking? The European economy is going from bad to worse. While economic and financial indicators from around the world have recently been disappointing, the US news has suggested nothing worse than the risk of another modest summer “soft patch,” while China has been settling into structurally slower, but still very impressive growth. By contrast, the news from Europe, including Germany, has recently been dire.
Yet European bond spreads are back to their levels before the 2010 Greek crisis and European equities have recently started to outperform, with the DAX rebounding to its pre-Lehman highs and even Italy, Spain and France now joining the party. The main explanations for this surprising strength appear to be the deal to form a new government in Italy, the pan-European resistance to German-inspired fiscal austerity and the hope of an ECB easing, maybe as soon as Thursday.
Our scepticism about Italian politics was explained in a comment last week. While we did not guess the name of the new Italian prime minister, events have broadly confirmed our view that Italy is back under Silvio Berlusconi’s effective control. The new PM, Enrico Letta, is an even weaker figure than the other candidates and more clearly under Berlusconi’s thumb (his uncle is Berlusconi’s chief political fixer). That makes a new politico-financial confrontation with Germany and the ECB likely by the end of the year. Or maybe much sooner, since Berlusconi’s vow to reverse a hated troika-imposed property tax hike is gaining traction among the ragged remnant of the center-left party Letta nominally leads.
Some investors, however, now seem to treat tensions between Germany on one side and Italy, Spain and France on the other as potentially good news, supporting the second reason for euro-optimism: imminent reversal of fiscal austerity. While the political and intellectual pendulum may indeed be swinging from austerity towards more Keynesian “deficit denial,” we would urge extreme caution on this score. New budget consolidation measures are indeed off the agenda, apart from Cyprus, but tax hikes and spending cuts already legislated will continue throughout this year in almost every country, with the possible exception of Italy. Any overt easing of fiscal policy is inconceivable until well after the German election on September 22. So it is pure wishful thinking to hope that economic activity or profits might enjoy some kind of fiscal boost this year.
Which leaves the third possible cause of euro-optimism: expectations of a monetary easing by the ECB. This is the strongest reason for hope, since it allows investors to treat bad economic news as good news that will bring forward the inevitable ECB easing. But it is also the most dangerous, since it could be dashed as soon as this week. Judging by recent comments from key ECB policymakers, the markets are overestimating the chances of an early monetary easing. And even if the ECB does announce a quarter-point rate cut on Thursday, this could well be a case of “buy on the rumour, sell on the news” since the ECB is very unlikely to hint at any plans for further “unconventional” easing and seems to have no intention of following the aggressive monetary expansionism of the Fed or the BoJ.
ECB hawks cite at least four specific reasons for resisting any significant easing. First and foremost, they believe that further rate cuts would do nothing to stimulate activity in southern Europe because the “monetary transmission mechanism” in Spain and Italy is largely broken. But secondly, they argue that the central bank has already done about as much to repair this transmission mechanism as it can. The credit crunch in Italy and Spain, they insist, is not due to lack of bank liquidity, which the ECB is able and willing to provide without limit. The problem is inadequate bank capital and the ECB cannot help with that.
Thirdly, these officials maintain that where monetary transmission mechanisms are not broken, further rates cuts or ECB balance sheet expansion would produce perverse results. In France, where the ECB sees no credit crunch at present, they worry that loosening monetary policy further will simply ease pressure on the government to undertake structural reforms, repeating the mistake made in Italy last year.
Meanwhile in Germany, interest rates are already negative and further cuts would cause more capital misallocation by inflating asset prices. Ominously for European equity investors, the asset inflation that really worries the ECB’s hawkish faction is not in German housing, which they see as merely recovering after a decade of stagnation, but in the German stock market, where price-earnings ratios are seen as becoming overstretched, as in the Fed bubble on Wall Street.
Finally, the ECB hawks see no reason to ease monetary policy to weaken the exchange rate. The main central banks of the world are divided into two groups, they argue. On one side is the Fed, which manages a continental economy with relatively little trade dependence and treats the dollar exchange-rate structure as a residual of its domestic monetary policy. On the other side is the Bank of Japan, which may not explicitly target the exchange rate, but certainly regards it as a very important monetary indicator and a key input into its economic forecasts. While the Swiss National Bank and the Bank of England are clearly in the BoJ category, the ECB is in the same category as the Fed. It manages a continental economy which is largely self-sufficient and therefore treats the euro exchange-rate as an output of monetary policy, not an input in policy deliberations.
Many politicians and economists disagree with these ECB arguments for doing nothing—but bullish investors in Europe would be rash to ignore them or simply wish them away.
Disclaimer: This information may not be construed as advice and in particular not as investment, legal or tax advice. Depending on your particular circumstances you must obtain advice from your respective professional advisors. Investment involves risk. The value of investments may go down as well as up. Past performance is no guarantee for future performance. Investments in foreign currencies are subject to exchange rate fluctuations. Marcuard Cyprus Ltd is regulated by the Cyprus Securities and Exchange Commission (CySec) under License no. 131/11.
