Europe steps into the quantitative easing game
For some time, we’ve expected Mario Draghi, president of the European Central Bank (ECB), to take measured steps toward stimulating Europe’s lagging economy. What we didn’t quite expect was that on January 22 he’d take a giant leap into the stimulus game: More than €1 trillion in bond purchases over the next few years – double what markets anticipated. Plus, the ECB signaled that if necessary those bond purchases are open-ended, a clear signal that it will do whatever it takes to get things moving in the right direction.
We believe Draghi has two main goals in mind. First, he wants to increase inflation expectations. The recent rise in the real interest rate, itself the result of falling inflation expectations, is considered unwanted monetary tightening that needs to be countered. Second, he wants to boost economic growth.
In our view, although quantitative easing (QE) won’t be a game changer for economic growth per se, the ECB is hoping that four transmission channels will likely help stimulate growth.
- First, a weaker euro. Besides boosting inflation, a weaker euro will likely provide a tailwind to economic growth through increased demand for eurozone exports. Sure enough, the euro dropped sharply after the ECB’s January 22 announcement.
- Second, the ECB wants to lower interest rates and thereby help to support consumption and investment. Even though interest rates are already very low, there is still some room for improvement, especially in the area of business loan and mortgage rates in the periphery.
- Third, the ECB hopes, but would never admit, that through the portfolio re-balancing channel, eurozone financial assets will likely rise in value. The associated wealth effect should help support demand.
- Finally, the ECB aims to help shore up consumer confidence by acting decisively against the threat of deflation.
In the months to come we’ll be looking for credit growth to pick up as confirmation that the recovery is gaining traction again. This may be a slow indicator but it is an important one. Right now that’s already looking improved with the latest ECB Senior Loan Survey reporting increased supply and demand for credit.
One thing we aren’t apt to see is any sharp uptick in inflation, regardless of the ECB’s goals. That’s due in large part to the sharp drop in oil prices, which is driving down prices for both consumers and businesses. But this is deflation we can love – lower prices for things people really need but can’t produce themselves. Currently, the ECB’s own calculations show the bond purchases will add 0.4% to inflation in 2015, and 0.3% in 2016. Draghi hopes that in conjunction with improving economic conditions, inflation will approach 2 percent within a few years.
All in all, the ECB’s actions reinforce our views on Europe as outlined in our 2015 Global Outlook – Annual Report. We forecast that the eurozone would outperform other major regional equity markets, and the ECB’s bond purchases will make that scenario even more likely. That gives investors opportunities to buy into an underpriced market that is moving in the right direction. We’re remaining overweight on eurozone equities. That being said, we also believe the euro still has room to drop, and will continue to trend down through 2015. Of course, as with any forecast, there are no guarantees of future performance of any equity or investment.
Europe certainly isn’t out of the woods. Unemployment stands at 11.5% across the Eurozone, as of November 2014 figures – double that in the United States , according to Eurostat. Greece, Portugal, and Ireland continue to fight deep government debt. And there’s always a chance President Vladimir Putin may cause more mischief to deflect domestic attention from Russia’s severe economic woes. But Mario Draghi and the ECB have taken a big, bold stride toward helping to ensure the European economy snaps out of its long nap.