From the moment in late June that Mario Draghi vowed to do whatever it took to save the euro, investors flocked back to risky assets. The reaction to the European Central Bank’s outright monetary transactions announcement, reinforced by the now validated expectations of American QE3, was the icing on the cake.
To the markets’ delight, Draghi's plan is technically strong and a smart, if covert, way of doing something that’s been rejected formally, namely leveraging the EFSF/ESM eurozone bailout funds. Unfortunately, the plan is also economically unsound. The Pavlovian market response to monetary financing will again falter because the ECB alone can’t resolve the euro crisis.
For now, world equity markets are on a roll, returning about 6 per cent since mid-year, with comparable returns to European bonds and energy markets. The next best performers include European investment grade corporate bonds, global listed real estate, and even the industrial metals and mining markets.
The ECB can take much, but not all of the credit. QE3 and the recent sudden confirmation by China of one trillian yuan of infrastructure spending spurred the biggest local stock market rally for more than eight months.
The strongest asset returns have accrued to European equities and precious metals. Gold has done even better. What does this tell us about investor psychology? Both asset classes thrive on the already bloated balance sheet of the ECB inflating further. ECB assets as a share of gross domestic product are already substantially higher than those of the Fed or the Bank of England. But gold will draw the more enduring sustenance from monetisation. Equity markets need much more to sustain their optimism.
Draghi has promised to remove the so-called tail risk in markets, allowing investors to focus more on normal asset class correlations, and valuation anomalies than on preserving capital. This risk derives from the self-fulfilling expectations of a eurozone break-up because of penal levels of interest rates in Spain and Italy, for example, especially those on short maturity bonds. The ECB is trying to break a vicious circle of exit risk, high real interest rates, poor sovereign liquidity and solvency prospects, economic depression, weak bank funding capacity, and so on. From this standpoint, the OMT plan is technically robust, and risk assets are right to cheer.
There are caveats. Spain and Italy have to ask for a troika program soon but might drag their feet. There would be consequences if the ECB didn’t shut down the OMTs if one of its supplicants were in breach of its conditions. And we don’t know if the surrender of seniority on OMTs is legally robust in extremis? OMTs will make official sector funding of sovereigns, and banks, even more crowded. Did someone say ‘zombies’?
But the principal reason why risk assets will falter again is that the plan is economically and politically unsound. Draghi’s insistence that the ECB’s actions are dependent on strict conditions is the price for German and other creditor government support. But this is precisely the problem. The single-minded emphasis on rapid fiscal restraint has created an unsustainable, pro-cyclical austerity zone. It is undermining weak sovereign and bank funding and solvency, and substituting national central banks, notably the Bundesbank, for private investors in financing regional capital flow imbalances, especially deposit flight from the periphery. Political sparks are flying in Germany.
The main flaw in the plan is the presumption that if countries need to apply to the EFSF/ESM for help, and for the ECB to authorise OMTs, it is because their austerity programs need strengthening under international monitoring. This makes no economic sense because it aggravates fiscal and economic instability, and no political sense because it is highly divisive within and between countries. There is nothing conducive here to the so far meagre but urgent progress needed for a banking union, including both a central resolution authority and pan-European deposit insurance, or for further fiscal integration, including centrally-determined behavioural rules and common debt issuance.
A sustainable recovery in equity and other risk assets would be accompanied by the return of stable, private financing of the eurozone periphery. The weathervane is a sharp rise in German bond yields, making the drift up over the summer just noise. For these things to happen, investors want two things. First, a plan to end the depression, which is not likely. Second, credible progress towards political union, which requires Germany and France and their supporters to agree radically different sequencing and substance agendas when it comes to sovereignty concessions. Draghi has drawn the markets’ attention away from these things, but not for long.
George Magnus is a consultant economist, and senior economic adviser, to UBS.
Copyright the Financial Times 2012.