ECB QE: A boost for markets but not a cure for all ills

The ECB announced full-blown quantitative easing (QE) on 22 January, by confirming that it would inject up to €1 trillion into the eurozone economy through the purchase of eurozone government and corporate bonds. The programme will run at the rate of €60bn a month (including the existing ABS and covered bond programmes) until the end of September 2016 or until there is sustained improvement in inflation and inflation expectations. The ECB has also improved the terms of its longer-term refinancing operations (cheap loans for banks), cutting the interest rate at which they are offered.

The market’s reaction so far has not been significant, as the ECB’s move had been anticipated widely. It is nonetheless pleasing that the ECB exceeded expectations as government bond purchases alone are likely to amount to around €40-45bn a month or equivalent to around €750bn over an eighteen-month period (the market had expected sovereign bond purchases in the order of €500bn as part of the programme). There has been some discussion in the media about the lack of „mutualisation? or risk sharing of the government bond purchases, but we feel that the important issue is the commitment from the ECB to expand its balance sheet. Risk sharing was always likely to be a stumbling block, particularly given strong German opposition to the idea, but it should not reduce the effectiveness of the policy in terms of addressing shortterm growth and deflation concerns. (Importantly, German policymakers have not questioned the legality of the ECB?s decision to implement sovereign QE, although it is clear that many Germans do not like the ECB?s decision.)

The fly in the ointment, if there is one, is Greece. If the anti-austerity Syriza party triumphs in the election, as seems likely, Germany may hope that Syriza will soften its stance once it is in government. If Syriza does not cooperate, Germany may feel that it can ask Greece to leave the eurozone. Unfortunately a risk premium would need to be applied if this were to happen, even if other peripheral countries (such as Portugal) decided that they wanted to keep the single currency.

The bottom line though is that the ECB has done everything that could have been reasonably expected and more. The tendency amongst investors will be to own more risk assets, particularly as the ECB?s move will help to keep interest rates low globally. Inflation should not rise excessively and we could see growth rates well above the cost of borrowing in many countries. That is normally a good environment for risk assets such as equities.

For European equities specifically, four tailwinds have emerged in quick succession:

A weakening currency

A weaker oil price

Sovereign Qantitative Easing

Lower valuations versus other world markets

Overall, we are positive on the financial market impact of European QE, if it brings down risk premia (such as peripheral bond spreads). Moreover, the economic background in Europe does appear to be showing mixed as opposed to negative signals (see the recent ZEW survey of investor confidence, which has jumped to an 11-month high, for example). It is also important to remember that the European stock market is not the same thing as the European economy; Europe is home to many world leaders, and many of these companies have strong positions within their particular industry or sector.

We have therefore decided to increase our weighting in European equities by 25 basis points in our asset allocation model, funded from cash. We also feel that, in general, the ECB?s move should reinforce demand for income-producing assets, and in that context higher-yielding equity markets such as the UK should remain attractive.