It doesn’t matter what Draghi does today – keep buying Europe

By John Stepek

published 6 September 2012

in Features

It's yet another day of reckoning for the euro.

Later today, Mario Draghi, head of the European Central Bank (ECB), will unveil the latest plan to save the eurozone.

Will his latest plan do the job? Or will it be yet another fudge that will leave the market disappointed?

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If you're a long-term investor, the truth is, it doesn't really matter

Draghi's fight to save the euro

Mario Draghi has said that he'll do whatever it takes to save the euro. Draghi argues that it's the ECB's job to protect the euro. Right now, bond markets are pricing in a break-up of the eurozone (that's why Italy and Spain's borrowing costs are much higher than Germany's).

Therefore, the ECB is well within its rights to put a stop to that. He wants to regain control of interest rates across Europe. The best way to do that is to print money to buy as many bonds as necessary to bring yields back to a less stressed' level.

The main thing stopping him is getting Germany to agree to all this.

It's very hard for Germany to sell the idea of bail-outs to its electorate. If the European Central Bank (ECB) prints money to buy the bonds of another country, that's inflationary. That inflationary pressure is likely to be felt most strongly in Germany. So bail-outs impose a cost on the Germans.

So you can see why they are opposed to handing them out too easily. The core problem is moral hazard'. Bail-outs shouldn't come for free. If they do, there's no incentive for the country (or bank) being bailed out to mend its ways.

Draghi's solution is to agree to buy the bonds of countries that are in trouble. But only if they ask for help, and agree to certain conditions.

So far, markets have broadly liked all this. The yields on Spanish and Italian bonds have come in, buoyed by the prospect of unlimited ECB buying. The cost of borrowing over two years for Spain has fallen from above 7% to just above 3% in the space of a month or so.

Trouble is, if Draghi doesn't deliver, that could all reverse.

So what does it mean for you?

Assuming you're a long-term investor, one of two things. If Draghi disappoints, it's going to give you a pleasant buying opportunity, as European stocks slump and markets have another fit of the vapours.

If Draghi doesn't disappoint, markets will rise, and you can stick to your plan of drip-feeding money in to the markets and stocks that you like.

In other words, it won't make a big difference.

Europe is cheap that's why it's a buy'

We expect money-printing to be the end game for the eurozone. But the main reason we like Europe has nothing to do with Draghi or Germany or anyone else.

It's because it's cheap.

You can argue that there are lots of good reasons for Europe to be cheap. It's true there are. But when markets fall to these levels, there are always good reasons not to buy. It's like the saying goes: "you can have good news or you can have cheap stocks, but you can't have both."

There's an excellent Deutsche Bank report doing the rounds just now, by strategist Jim Reid and colleagues. It takes a detailed look at long-term returns across bond and stock markets across the globe.

What's impressive is that, unusually for a mainstream piece of research, it identifies the final ditching of the gold standard in 1971 as playing a key role in the financial crisis. "With nothing backing paper money, the path to almost unlimited credit creation had begun." So began our modern era of rolling asset bubble-blowing, culminating in the great financial crisis, which has yet to end.

The report makes plenty of other interesting points, which I'll delve into in future Money Mornings. But I'm just highlighting this particular point because it suggest to me that the authors have a good handle on what's going on.

So what's their take on European equities? In short, they are "cheap to very cheap" relative to history and also to the US. We're not just talking about the likes of Spain and Italy here. Even Germany and France have rarely been cheaper measured on a cyclically-adjusted price/earnings basis. (The CAPE involves comparing the price to average earnings over the past ten years. That helps to smooth out any distortion from cyclical spikes and troughs in earnings).

Now, the Deutsche Bank team doesn't declare that you should throw caution to the winds and pile in. Given the trouble that Spain and Italy are in, earnings could fall further. In that case, "peripheral European equity markets would likely go from cheap to extraordinarily cheap."

However, "if the ECB is about to commit to a long-term euro-saving mission, then there's a large amount of potential upside for European equities, especially in the periphery."

Meanwhile, "for the more risk averse, German equities may represent a better risk/reward profile as we enter unknown territory."

We'd be more relaxed about buying Italy and Spain if you're taking a long-term view (let's say ten years here). Because what this comes down to is a choice between inflation and deflation. Both are painful, but deflation is the most politically painful. That means we'll end up with inflation.

So even if Germany somehow stops the ECB from printing money, all that will happen is that Spain or Italy will end up being forced out of the eurozone. At that point, they'll do their own money printing.

But if you'd rather stick with Germany or core' European markets, there are plenty of exchange-traded funds and investment trusts that let you pick and choose. We listed some of our favourites in our recent MoneyWeek cover story on the topic.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.