The ECB boss has fired up the printing press. To what end? James Ferguson explains.
Greece has hogged the headlines this week for obvious reasons. But the much bigger European event last week was European Central Bank (ECB) boss Mario Draghi's decision finally to launch quantitative easing (QE). Experience teaches us three things: QE will go on for a lot longer than anyone expects; it'll be bad for the value of the euro; and it'll be good news for share prices in the region. Here's why.
During a normal downturn, central banks aim to lower interest rates to encourage banks to lend more money, more cheaply, to businesses and consumers. More lending means more spending and investing, and more growth. But when banks face a solvency threat in other words, they're in danger of going bust they don't want to lend more money to the private sector because their balance sheets can't cope with the risk of potential loss. Instead, they want to reduce their outstanding loans, and use any profits they make to recognise and write off bad debts. This reduces the money flowing around the economy and hurts economic growth.
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The banking system in the euro area is €31trn in size. The key part of that is the €11.8trn in loans to the real economy the private sector. Because despite constant fretting in the press over the dangers of government bonds, the real issue in sorting out an international banking crisis is the long process of dealing with the bad debt write-offs incurred on private-sector loans.
So where are we now?
The level of euro area bank loans outstanding peaked in 2011. Some water has flowed under the bridge since then. But if a look at 27 of the largest banks in the euro area is anything to go by, so far cumulative loan losses remain below 6%. If history is any guide, the losses will be closer to 15%. So we could still be looking at another €1trn or so of private-sector loan losses. That's pretty poor when you consider that the US banks have now crystallised almost the entirety of their own post-2007 loan losses.
Banks facing these sorts of losses are in no position to lend. That's why central banks do QE. QE pumps money back into the economy while the injured banks are sucking it out. Money supply growth (which is usually driven by bank lending) is very closely linked to nominal GDP growth. If you can't grow the money supply, you can't grow the economy. So if banks have €1trn in losses left to sort out, this implies that QE has to amount to at least €1trn, just to prevent deflation. But the ECB is meant to keep inflation nearer to 2%, so extra QE is needed to boost inflation too.
On Draghi's current plan of printing €60bn a month, QE will create €600bn this year, and around €550bn in 2016. Now if you look at the ECB's estimates of underlying bank profits, then assuming everything went smoothly, the banks should be able to deal with €1trn of bad debt in just three years. But I'd expect this process to be spread out over the next five years, for three main reasons.Firstly, €350bn-€400bn of QE is needed just to keep money supply growth consistent with the 2% inflation target.
So if the ECB is printing €600bn a year, that suggests it expects banks to write off about €200bn a year. At that rate, it would take five years to finish clearing the bad debts. Secondly, in the US and UK, central banks paused between bouts of QE. A similar stop-start timescale in Europe could easily see euro area QE last until 2020.
Thirdly, QE in both America and the UK amounted to more than 25% of GDP.For the euro area, that would imply €2.65trn of QE. At the current rate of €550bn-€600bn a year, that would take four and a half years, without breaks.In short, don't expect euro area QE to end for good on the September 2016 deadline.
What QE does
So QE is most likely here to stay (German reservations aside). And the Anglo Saxon experience means we know what to expect. Firstly, contrary to popular opinion, QE makes bond yields rise (ie, bond prices fall). This makes sense QE is inflationary because it expands the money supply, and bonds don't like inflation. During QE1 in America, ten-year Treasury yields rose from 2% to 4%.In QE2, they went from 2.5% to 3.5%. Yields also rose during Operation Twist and then had another big move up (from 1.6% to almost 3%) during QE3. Only when QE3 was being wound back (tapered) did yields start to fall again, though not by much.
QE also dilutes the currency, so foreign holders of eurozone government debt will be particularly penalised. In effect, QE is a soft default, in that foreign creditors get paid back in a devalued currency. Sterling fell by 25% between the start of the crisis and the end of QE. So those are two very good reasons for absolutely any bond investor to want to sell bonds so despite their early enthusiasm, euro area bond markets will suffer during QE.
QE also won't bail out the banks, nor encourage them to lend, because it's not supposed to. As I've already pointed out, when banks are repairing their balance sheets, they don't expand lending. This is what the last three years have been like for the euro area. The biggest danger to the wider economy, however, is that banks are now redirecting their retained earnings towards absorbing previously unrevealed bad debts this is what threatens to cause deflation.
The ECB (or at least national central banks with ECB money) offsets this by buying long-dated government bonds from non-banks (such as pension funds, for example). This creates a new deposit in the seller's bank account (because this money was printed out of thin air).
That makes new deposit liabilities at the commercial bank go up and it boosts banks' reserve assets at the central bank, so banks' total assets and liabilities increase. Note, however, that neither bank loans to the real economy nor banks' capital are directly affected by QE. There is no bank bail out because QE doesn't flow to bank capital and nor does it absorb losses.
So QE itself, by design, doesn't reach the things that banks are most exposed to such as private-sector loans. Instead, the printed money disproportionately flows to traded assets, such as equities, or goes offshore (as the sellers of the government bonds invest in something else). Really what it does is to buy time while banks repair themselves. And the pace of that process will be set by the speed of loan loss write-offs, which in turn are determined by bank earnings. Deutsche Bank has already complained that QE will squeeze its net interest margins (ie, the amount of money it makes), so there's yet another reason not to bet on euro area QE ending on schedule.
The euro has further to fall
If the ECB does end up printing in the region of €2.5trn as I expect, that suggests we'll see a peak-to-trough decline in the euro of about 20%-25%. The euro has already dropped by about 12% since last March. So that fall almost exactly reflects the impact of the €1.1trn in QE that Draghi has announced to date.
That's a pretty big move already, and it may be tempting to think that the currency moves are all already baked in for now. However, I would point out that the UK saw sterling fall by the full 25% during the first 18 months of the crisis, and it then stayed down in a narrow range for another five years after that.
In sterling's case, the currency market was a remarkably able and reliable forecaster of the quantity of QE that was ultimately required. In short, the euro is no bargain, even down here.After several years' experience of QE in the US and the UK, we now have a pretty good idea of what QE can and can't achieve, what it's meant to accomplish, what it almost definitely won't do, how long it is most likely to last and how large it'll probably end up being (all assuming, of course, that the German Constitutional Court doesn't put the kibosh on the whole thing).
So summing up, here's what I expect. QE will weaken the euro (and keep it down). It'll last for four to five years and most likely end up totalling more than €2.5trn. What will it achieve? It will make euro area money supply, nominal GDP and prices growth better than they would otherwise have been. And it'll prevent outright deflation. But nevertheless, it will condemn the euro area to stagnant growth, as well as intense social and cross-border distribution divisions.
As important as what to expect is what not to hope for. QE won't support bond markets, encourage bank lending, nor bail out the banks. However, there is one unmitigated plus point: euro area equities should do really well you just need to be hedged against the weak euro. See the box on the left on some ways to do this.
James Ferguson is a founding partner of the MacroStrategy Partnership LLP (macrostrategy.co.uk).
How to hedge your European bets
As James notes, writes Matthew Partridge,QE tends to be bad news for bond markets.A better time to buy bonds has been whenQE is ending, rather than beginning. But wedo expect European shares to do well from thelatest round of QE. The tricky issue is the fallin the value of the euro.
This isn't necessarilya bad thing, as a cheaper euro will helpexporters, and overall the equity gains shouldoutweigh any currency losses. However, youcan enhance your returns by buying a fundthat is hedged against falls in the value ofthe euro. What this means is that, as well asbuying European shares, they also bet againstthe value of Europe's currency.
One managed fund that has a good trackrecord is the JP Morgan Europe Dynamic(ex-UK) Fund C (GBP Hedged). As its namesuggests, it is hedged against the value ofsterling, so if the pound does well against theeuro you should get better returns. It doeshave a total expense ratio of 1.5%, which isslightly on the expensive side. However, this isjustified by its performance, since it returned16.7% in the last year, compared with 5.6% forits benchmark.
With the dollar expected to continue to rise,you might want to consider a dollar-hedgedfund instead. One exchange-traded fund(ETF) that looks attractive is the DeutscheX-trackers MSCI Europe Hedged Equity(USD Hedged) (NYSE: DBEU). This ETF has amanagement charge of 0.45%. Bear in mindthat there's an extra layer of currency riskhere, and as with the JP Morgan fund, do beaware that if the euro defies expectations andrises in value, the hedging will act as a dragupon returns.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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