Schroders: QE to provide welcome eurozone boost

Azad Zangana, Senior European Economist & Strategist: 

European Central Bank (ECB) President Mario Draghi has announced that the central bank will purchase sovereign debt along with agency debt in order to combat the rising risk of deflation. Despite considerable doubts from Germany, the ECB will follow in the steps of the Federal Reserve, Bank of Japan and Bank of England by introducing quantitative easing (QE) - expanding its balance sheet in an attempt to weaken the euro and raise domestic demand.

Draghi announced that the new additional purchases combined with the existing asset backed securities (ABS) and covered bond purchases will total €60 billion per month starting from March until September 2016 - totalling €1.1 trillion (11% of GDP), or roughly what is required to take the ECB’s balance sheet back to the peaks seen in 2012. This is about twice the size expected by the market consensus and as a result, the euro is trading lower against the US dollar and sterling, while European government bonds are seeing falling yields (rising prices).

Eurozone inflation fell below zero in December and is very likely to fall further in coming months thanks to falling energy prices. While we see this as a positive development for growth and medium-term inflation, in the near-term at least, there is a risk that households’ inflation expectations become de-anchored and they start behaving in a more deflationary manner. If households start to believe that prices will continue to fall, they may be tempted to hold back spending to achieve lower prices, which in turn will push prices down further thanks to the lower demand. This would reinforce the lower price expectations, and cause a downward spiral in prices – Japanese style deflation.  This is not our central view, and today’s action from the ECB further reduces the risk of deflation.

The obvious question is will QE make a difference, especially as government bond yields in Europe are already so low? There is certainly scope for bond yields in peripheral Europe to fall further, and for those lower interest rates to feed through to the real economy via the banking system, however, we feel that the main impact will come through from the weaker euro, which will make European exporters more competitive internationally. 

The issue of risk sharing in the event of losses was also answered today. Germany appears to have been against the idea of any risk sharing should an issuer look to default on the bonds purchased, but markets were concerned that without risk sharing, the programme would lose any credibility. In the end, the ECB has decided to share the risk on 20% of the purchases, with the remaining covered by individual central banks. 

Importantly, the ECB has stated that it will only purchase investment grade debt, with an option to buy the debt issued by lower rated sovereigns for those in a bailout programme. This covers the ECB should the Greek election this weekend result in a government that seeks to end Greece’s bail-out programme. Finally, the ECB announced that it would stand equal with private investors should losses be incurred (pari passu), which reduces the incentive of forced restructuring.

Overall, we think the ECB’s QE programme will benefit the eurozone economy by reducing the risk of deflation; however, it is not a panacea for the monetary union’s ills. Deep structural reforms are required in order to raise Europe’s potential trend growth. Without structural reforms, the ECB may be forced to add additional stimulus in the

future as growth falters again.

Rory Bateman, Head of European Equities:

The ECB confirmed today it will embark on investment grade QE at €60 billion per month until at least September 2016 and will continue until inflation moves towards 2%.

This is greater than market expectations and represents a significant event for Europe, reflecting Mario Draghi’s concern about price deflation across the eurozone which has been exacerbated by the weaker oil price. 

The issue of ‘mutualisation’ (i.e. the ECB taking the loss in the event of debt default rather than national governments) was dismissed by Draghi as an irrelevance as it would not impact the effectiveness of the programme. We would agree that explicit risk sharing is highly unlikely given the imminent Greek elections and take this QE at face value as an extreme monetary stimulus for the region. Whilst the detail is still emerging, we believe Draghi’s announcement is positive for asset prices in Europe and particularly for European equities. Equity markets have performed well during QE in other countries around the world and Europe is likely to follow. We have already seen euro weakness versus other currencies which may well continue given today’s release. This will be beneficial for European exporters and when combined with a lower oil price and the resultant impact on consumer spending should ensure upward pressure on corporate earnings during 2015.  

We have said on previous occasions that monetary policy in isolation will be insufficient to transform the European growth outlook but this announcement is in our view a significant incremental positive. We continue to believe the economic recovery will be slow and bumpy in the eurozone, but the equity market offers decent upside given attractive valuations relative to other markets and alternative asset classes, as well as a more favourable outlook for corporate earnings given the currency tailwind, lower oil price and a normalisation of the banking sector.