Last week, the European Central Bank moved into uncharted waters, becoming the first major central bank to announce a negative deposit rate. In somewhat of a desperate move to stimulate lending on the periphery of the eurozone and push inflation higher, ECB President Mario Draghi cut the main refinancing rate by 10 basis points to 0.15 per cent and the deposit rate from zero to minus 0.10 per cent.
This means that banks will now be charged to park their money with the ECB, in a measure designed to encourage lending by European banks. In doing this the ECB is trying to depress the euro, stimulate economic growth and stave off the threat of deflation.
The ramifications of this move are potentially wide-reaching. With yields on European bonds now significantly lower, money is flowing towards other nations' bonds that have significantly higher yields, while high-yielding equities are also seeing increased demand.
This is where Australia is affected. Australia offers the highest sustainable yielding equities of any nation, which means that European money, as well as money that is invested in Europe, is finding its way into Australian high-yielding equities as well as Australian government and corporate bonds.
Australian banks could be one of the major beneficiaries. Demand for Australian bank bonds and mortgage-backed securities is driving bank funding costs lower, which has historically been positive for the sector. This demand for Australian securities is likely to see the Aussie dollar flat to higher, in turn causing its own set of headwinds.
As well as supporting Australian high-yield equities, the ECB’s decision reaffirms our positive view of European stocks. We see earnings per share growth in the euro-area exceeding that of any other major region over the next three years with the economic recovery appearing increasingly robust on the back of domestic demand.
With the current inflation backdrop, ECB quantitative easing is a real possibility, especially if PMIs were to fall sub-50 on a sustained basis. The impact QE had on US equity markets is there for all of us to see.
We reiterate our view from January this year that most portfolios should have some exposure to Europe. Back then we recommended a couple of ideas that offer European equity exposure, those being iShares S&P Europe 350 ETF (IEU) and Templeton Global Growth Fund Limited (TGG).
While neither the ETF nor the listed investment company have set the world on fire in the interim, we still believe they represent good value for investors.
The iShares S&P Europe 350 ETF is traded on the ASX, is physically backed and seeks to provide investment results that correspond to the price and yield performance of the benchmark (S&P Europe 350 index) by investing in all the shares that make up the benchmark.
Meanwhile, the Templeton fund offers investors access to a diversified portfolio of international securities.
As at 31 March, TGG’s largest exposures by region were Europe (44.5 per cent) and North America (32.5 per cent), and by sector were Financials (21.5 per cent) and Health Care (17.4 per cent).
The euro region has the most earnings catch-up potential globally, with EPS still about 30 per cent below 2008 levels, while US EPS is some 20 per cent above the levels in 2008.
The ECB's moves last week should lead to a weakening in the euro, which would remove an important obstacle for any potential earnings recovery in the region, given that more than half of corporate revenues come from outside the euro area.
Ben Potter is retail editor at Baillieu Holst.