"Not to pursue our mandate would be illegal” is how Mario Draghi ended his last press conference of 2014. Mr. Draghi’s first press conference of 2015 began with the announcement of a quantitative easing (QE) programme that pursues the European Central Bank’s (ECB) inflation mandate with a vengeance. And rightly so, for the disinflationary trends in the eurozone had become all the more precarious as economic output and the price of oil continued to fall.
The size of the QE programme is on the upper end of market expectations. Beginning in March 2015, the ECB intends to purchase €60 billion worth of bonds per month until September 2016, implying a little over €1 trillion in asset purchases across eurozone government and agency bonds, but also encompassing the existing covered bond and asset-backed securities purchase programmes.
Where this QE programme differs from those of other central banks is the open-endedness implied by tying it to a future point in time when “we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term” (my emphasis). With inflation currently at −0.2% and with the ECB anticipating 1.3% inflation in 2016 – and that was before the price of oil fell to $50 a barrel – a sustained adjustment in the path of inflation back toward target may take quite some time to achieve, hence opening up the possibility of purchases beyond 2016 and leading us to conclude that the ECB is taking its mandate very seriously indeed.
While we were initially concerned about how eventual losses on bonds purchased under QE might be distributed across the ECB and its 19 shareholders, the national central banks (NCBs), in the end we concluded risk-sharing is not really an issue at all: 20% of the bonds purchased by the ECB and NCBs will be subject to risk-sharing, 80% will not. On the latter, each NCB will buy its own government’s bonds and bear the risk. In the hypothetical event of a loss, only the NCB whose government defaults will participate in the loss. Most importantly of all, however, because central banks can operate on negative equity, and because private banks’ claims on the reserves created by QE are enforceable throughout all of the eurozone, risk-sharing is – as Mr. Draghi said in the press conference – “irrelevant.”
Will QE work? Let’s not kid ourselves: Monetary policy can help steer the business cycle, but sustainable growth ultimately derives from investment, productivity and population growth. And for that, both the private and public sectors will be required to contribute their parts too.
European policymakers appear to have struck a grand bargain of sorts that suggests this QE programme can be successful. The ECB has delivered its part. The European Commission is coordinating a public-private infrastructure investment fund that it hopes will reach €300 billion, and a number of the national governments are getting serious about structural reforms. Prime Minister Matteo Renzi stands out for reform initiatives of Italy’s labour market, electoral system and banking sector, and while not every reform has been passed into law yet, on this front Europe is definitely changing for the good.
Market and investment implications
What about the market impact, and how do we think about portfolio strategy from here? A generalisation of QE experiences in the U.S., U.K. and Japan suggests QE is good for risk assets and gold and bad for duration and the external value of the currency being printed. While Japan is an outlier on duration, we think the eurozone will experience similar dynamics as the other QE countries.
Peripheral government bonds have performed well in the past but we see few reasons to part with them. At about 2.7%, yields on longer-maturity Italian and Spanish government bonds offer a non-insignificant pickup over similar maturity bonds from Germany. We would expect these yield differentials to diminish.
We continue to see opportunities in investment grade and high yield corporate bonds. Eurozone bank stocks and subordinated bank capital securities have underperformed their corresponding sovereign bond markets of late, and the ECB’s actions would appear supportive of some catch-up.
Further out what PIMCO calls the investment concentric circles, less liquid and higher-risk asset classes, such as real estate and distressed debt, are expected to benefit from easier monetary policy. PIMCO’s capable team of real estate and private equity analysts will have their work cut out for them in the months ahead scouring for opportunities in these fields.
We see less value in the low yields on German government bonds and in currency exposure to the euro. The €33 rise in the price of an ounce of gold by the close of business in Europe on Thursday (22 January) is evidence of what can happen when the supply of one asset rises relative to another. The euro is likely to continue its depreciation.
Thinking more broadly, we also need to consider the global ramifications of the ECB’s decisions. The world economy has experienced 35 years of broadly uninterrupted disinflation that culminated in zero policy rates and QE in all major developed markets. While cyclical economic strength has re-emerged in the U.S. and the U.K., the sheer weight of slower growth in the rest of the world, particularly when China and other emerging markets are brought into the equation, and particularly in light of aging demographics, will have implications for just how far the Federal Reserve and Bank of England can normalise their policy rates.
Markets continue to believe in the power of central banks to engineer economically desirable outcomes. Should that belief be called into question, and central banks throw in the towel as the Swiss National Bank did, the disinflation trend could tip into debt-deflation. For now at least, the ECB will blow on the embers of its reflationary fire.