Last week, to counteract slowing growth and stubbornly low inflation, the European Central Bank cut its deposit rate by 10 basis points to –0.5%, and announced a second quantitative easing (QE) program. The ECB will purchase EUR 20bn of assets a month starting 1 November, with no fixed end date. It also announced easier terms on TLTRO borrowing, which lowers bank funding costs, and deposit tiering, which offsets the impact of negative deposit rates for banks. Will the policy package succeed?
In our view, there are reasons to believe the easing measures are not enough to change our underweight of European equities in relation to other regions
- Beyond a certain level, negative interest rates become counterproductive. For banks, this point is known as the “reversal rate,” where the positive revaluation effect of lower rates on banks’ fixed income assets is outweighed by falling net interest income. While it is difficult to pinpoint this rate, it’s notable that the Euro Stoxx bank index hit a 7-year low in mid-August when 10-year Bund yields reached a record low below – 70bps. Individuals, meanwhile, may respond to lower rates by reducing spending, reflecting falling interest income from their cash balances.
- Part of the rationale behind the ECB’s first QE program was to lower longterm rates to encourage borrowing. But with 10-year yields already firmly negative there may be little scope to push them significantly lower. In any case, the new QE program may not be large enough to have much impact. Asset purchases are open-ended, but the program will be constrained by eligible assets. ECB President Mario Draghi said there was "no appetite for changing issue or issuer limits.” In our view, if issue/issuer and capital key constraints are not changed, the new program may ultimately amount to only EUR 0.3–0.6trn. This compares with the EUR 2trn of the first QE program.
- Arguably, it would be more productive to have a steeper yield curve, which would benefit bank profitability and foster confidence that ECB policies will work. The ECB has committed to keeping rates at current levels or lower until it achieves its inflation target on a persistent basis. But the inability of the ECB to achieve its inflation target a decade after the crisis may undermine the credibility of its guidance, limiting its ability to both raise inflation expectations and encourage a steeper curve.
The ECB has tried to address these shortcomings where possible. Deposit tiering is aimed at mitigating the impact of negative rates on bank income. The rationale for announcing a package is also that policies may be more effective when combined than if they were introduced piecemeal. But overall, we expect the effectiveness of further monetary easing to be less than in the past, and Draghi acknowledged this in his comment that “now is the time for fiscal policy to take charge.”
Amid growing awareness of the need for fiscal policy to support the economy rather than just focus on financial stability, the EU executive commission will reassess its fiscal rules by the end of the year. Germany has opted to maintain its balanced budget stance for 2020, although policy has been eased within the available constraints, and additional climate and infrastructure-related spending might yet be approved. That said, in our view, any additional German stimulus will likely be reactive and gradual, rather than proactive and immediately growth enhancing.
At present, it appears unlikely that either fiscal or monetary stimulus will be sufficient to generate a swift rebound in growth and inflation, or a sharp steepening of the yield curve.
Staying strategically invested in equities is important, and with Eurozone equities offering an earnings yield of 6.8%, the longer-term appeal is clear. But with economic growth slowing, profit growth in 2020 likely to be negative, and the region relatively highly exposed to global trade risks, the ECB move has not inclined us to become more positive on Eurozone equities, which we remain tactically underweight on until at least some of these headwinds clear.
Within equities, we prefer US and Japanese stocks that are better placed than Eurozone equities in an environment of heightened risk and growth uncertainty. While we continue to recommend an underweight to international developed and emerging markets stocks, we recommend a neutral stance on US stocks. We also recommend an overweight to emerging market USD-denominated bonds and Treasury Inflation-Protected Securities (TIPS), which benefit from central bank easing in a low-growth environment.
In an effort to counter slowing growth and persistently low inflation, the ECB has pushed rates further into negative territory, provided help for banks, and reintroduced quantitative easing. But monetary policy may be approaching the limits of effectiveness, which was acknowledged by ECB President Mario Draghi. Against this backdrop we remain underweight equities and recommend an overweight to EM fixed income, where yields are attractive versus similar-risk corporate bonds; and TIPS, which should benefit from higher inflation expectations.