The EU rescue and your portfolio

High-yielding shares will be the first to benefit if this week’s dramatic ECB rescue plan for Europe works … interest rates may fall too.

PORTFOLIO POINT: Share prices have rallied on the back of the measures announced by the European Central Bank. But with interest rates likely to fall, that also means lower fixed-interest rate returns.

The rescue measures announced last night by the chief of the European Central Bank, Mario Draghi, to buy unlimited volumes of bonds from indebted eurozone countries will dramatically change world capital markets.

Global sharemarkets, including our own ASX, have already rallied in anticipation that the steps by the ECB will ease Europe’s woes. If they fail we are headed for very turbulent times, but if they succeed the rules of the investment game will definitely change. Let me isolate some of those game changers as they apply to Australian investors.

  • When Draghi made his announcement, two of the biggest stock price jumps were JP Morgan and Bank of America. These companies are integrated into the global banking system, and if the Draghi measures are successful it will remove a major threat to global banking.
  • But Australia is also integrally bound to the global banking system because our major banks gain 40% of their funding from overseas wholesale lenders. If Europe collapsed, that market would freeze. Our banks have been fearful of an overseas wholesale funding freeze, so they have been undertaking a major drive to reduce their dependence on overseas borrowings by increasing their local term deposits. They will still do this, but the urgency is removed. That means that term deposit rate margins over the official rate set by the Reserve Bank are likely to fall.
  • Official Australian interest rates are also likely to fall, partly because of the removal of the threat that global capital markets will freeze, and partly because events are turning against the Australian economy and we are going to see a rise in unemployment and continued massive cancellations of resource projects. Lower rates should help the struggling Australian housing market.
  • Metal prices did not rise after the Draghi measures because it will not increase demand for metals, which is not good news for our miners or the Australian dollar. On the other hand, the announcement of a massive Chinese subway project is a sign of action in China.
  • The bottom-line strategy for Australian investors is, you can lift your equity percentage to the level where you are comfortable (see A split decision on buying equities and Review your equities comfort level for an explanation on this strategy). Buying for yield makes sense, provided you are confident the company can maintain its profits. Although Australian banks will be buffeted by the tougher Australian economy their access to lower-cost funding will greatly help them. If you are increasing your equity exposure, start with the banks and you can extend that to other high-yielding investments like Telstra.
  • European shares have been priced for a disaster. They are likely to perform well, although the European economy is going to be tough for an extended period.
  • In your interest-bearing securities sector, lock in longer-term term deposit rates because the rates are likely to fall.

All of this assumes that the Draghi plan will work, and there are plenty of commentators saying it will not. In essence Draghi is saying that if a troubled European country like Italy and Spain undergoes austerity and labour rule changes to make it easier for people to be employed, then the ECB will buy unlimited amounts of one to three-year bonds.

It will fund those bond purchases by issuing ECB Treasury notes, so in that way it can’t be accused of money printing. The program falls to pieces if a country signs up to austerity and labour reforms, the ECB buys its bonds, and then the government in that country changes and austerity is thrown out the window, and the ECB loses heavily on its bond investments. Alternatively the Draghi plan could fail if the world does not support ECB T-notes, so the program then becomes a money printing exercise.

Thirdly, the German central bank (the Bundesbank), which is opposed the Draghi plan, could cause trouble. The Bundesbank has been overruled ruled by German Chancellor Angela Merkel, who feared that Italy would leave the euro and use a low value lira to decimate German industry. The Bundesbank president, having been overruled, did not resign because Merkel urged him to stay.

We have seen many efforts in the past to prop up the European situation, but in my view the Draghi plan has the best chance of succeeding because the leaders of Italy, Germany and Spain have effectively come together in a way not seen before. And because they have come together, the ECB can take action. But Europe still faces many years of hard times and the political fallout from austerity will not go away, which may see the current leaders replaced.

We are still in the process of deleveraging balance sheets. A vast amount of money has left Europe, and this plan must attract it back via support for European shares and ECB T-bonds.

A major hazard is Greece, but this plan lessens the fallout from a Greek exodus. Greek Prime Minister Antonis Samaras will meet Draghi in Frankfurt next week. My guess is that meeting will lock Greece in, but the terms will be harsher than those given to Spain and Italy. Greece has lost its leverage.  

Coming back to Australia, you should be aware that vast numbers of Australian corporations have effectively gone on a capital strike and substantially curtailed their capital spending. This has been obscured by the massive amounts being invested in committed mining projects. But almost all new mining projects are being mothballed.

This will be a tough time for a lot of Australian companies and we are not going to see a rise in bank profits. But a big threat to the banks has been removed, so the attraction of their yields is greatly increased. For the sharemarket to really take off, what is needed is a further major stimulation in China. The Chinese economy has slowed and the efforts to stimulate it again have so far not been effective. We are in the process of a changing Chinese administration, so stimulus is being delayed. Nevertheless China cannot afford to have low rates of growth because of social implications and, in due course, they will take steps to lift economic activity.

Of course, what really pumps world sharemarkets is quantitative easing in the US, because a large amount of this money seeps into share speculation. American markets are now close to their peak level because US companies have used the last few years to dramatically increase their productivity, and their profit share of the total economic pie has risen sharply. Neither presidential candidate plans to change this, so Wall Street believes that any significant improvement in the US economy will send profits rising sharply.

We are seeing a rush of money to equities in the aftermath of the Draghi measures. Timing is always hard, because there will be good and bad days, but this package increases the odds of Europe staying together and avoiding a freeze in the wholesale banking market. Interest rates are set to fall. This is good for equities, particularly those that yield.

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