ECB: A QE Update

Apart from setting a date (March 9th) for the beginning of its asset purchase program, the ECB filled in some other details around its policies.

In the press conference introductory statement, President Draghi announced upward revisions to growth over the next year, but revisions to inflation forecasts were down (to 0% for 2015). But it was in the Q&A that more light was shined on QE policy. The major point gleaned from the Q&A is that the central bank is not prepared to buy bonds yielding less than the deposit rate.

That stipulation then begs the question: What happens if there is not enough liquidity for the ECB to buy €60 billion per month if the central bank will not buy any asset with a yield below the deposit rate? One answer is that the ECB could lower the deposit rate. We believe that given the choice between a lower deposit rate or not attaining the €60 billion in monthly purchases, the ECB would likely do the former. The ECB will be disposed to finishing the 19 months of quantitative purchases in order to protect its credibility, unless of course the economy is strong enough to warrant stopping early.

So far, the ECB is not showing concern that there will not be enough sellers of high-quality bonds for the ECB to buy. Draghi more or less dismissed the question during the Q &A and also alluded that he thought there were plenty of foreign sellers.

We have pointed out in Daily Insights that, in fact, the shortage of government paper is acute, especially in Germany, where there will be very little net new issuance. The government last week issued a 5-year Bund for the first time sporting a negative nominal yield (-8 basis points). Almost 30% of the continental European bond market is currently trading in negative territory, and the ECB hasn’t even started buying yet.

Negative yields are helping keep the euro weak, which, much like QE elsewhere in the world, is giving a definitive boost to local growth, and for the time being, equity markets. We maintain overweight positions in euro area stocks relative to the U.S. and global benchmarks.

Chinese Monetary Policy And Stocks

While the latest rate cut is clearly positive and is long overdue, the PBoC is still behind the curve. Monetary conditions remain far too tight, and further easing is likely.

Speaking at China’s annual parliamentary hearing, Premier Li Kequiang noted that, “The downward pressure on China’s economy is intensifying,” and that 2015 would be a tough year for growth. Indeed, the Chinese government downgraded its official target for growth to ‘around’ 7%.

Amidst this sober evaluation, China’s monetary conditions index has continued to deteriorate, driven by both rising real rates and a rising currency. This is disconcerting for asset prices, especially domestic A shares, as the market has rallied strongly since mid last year and is no longer cheap. The rally has partly been driven by expectations of policy easing and an improvement in monetary conditions – which have clearly failed to materialize.

For now our China strategists maintain a neutral rating on domestic A shares, as the risk-return profile of this asset class is roughly balanced. On one hand, there is a strong case that the PBoC should continue to ease, which will eventually lead to improvement in monetary conditions and a bid up in stock prices. On the other hand, the market may disappoint if investors decide that policy easing so far has not been effective and the PBoC continues to drag its feet. In this environment, any aggressive directional bet would be premature.

Deteriorating monetary conditions also bode poorly for investable Chinese stocks, but the case for this asset class is strengthened by attractive valuation. Chinese investable shares are still trading at hefty discounts to their historical averages – which justifies risk-taking, especially within the broader backdrop of monetary easing. The case for relative outperformance of Chinese investable stocks versus the EM benchmark is more compelling. China is among the few countries that have ample room for monetary easing, and Chinese stocks are still trading at discounts to their EM and global peers despite the past two years’ sharp outperformance. Chinese investable stocks will likely continue to be positively rerated going forward.

U.K. Election Preview

In a recent Special Report, our European and geopolitical strategists discussed investment implications of the upcoming U.K. elections.

The U.K. general election is set for May 7, with the outcome too close to call at this point. If we had to put our money on the outcome, we would favor the center-left Labour Party to pull off a tight victory that produced a center-left coalition with either the Liberal Democratic Party (Lib Dems) or the Scottish Nationalist Party (or both).

The election is likely to have only a modest impact on the equity market. The reason is that over time, the U.K. stock market has become a collection of large multinational companies that are listed on the London Stock Exchange but have very little exposure to the U.K. economy or politics. The main driver of the U.K. stock market’s relative performance is its sector skew: overweight Energy; underweight Industrials, rather than domestic economics and politics. Hence, the FTSE100 outperforms when Energy outperforms Industrials and vice-versa.

However, the election outcome will be much more significant for the interest rate and gilt market as well as the pound. A center-left Labour-led government is likely to slow down the pace of austerity. The U.K. has one of the largest budget deficits in the developed world and its fiscal thrust is expected to be deeply negative in the coming years. A Labour-led government, particularly one supported by the more left-leaning SNP, would slow the pace of consolidation. Together with the recent improvements in the labor market, consumer confidence, and real wages, this could force the Bank of England to tighten monetary policy earlier than the market is currently expecting – putting upward pressure on gilt yields and the pound.

Furthermore, a win for the pro-EU Labour government would remove uncertainty over the EU referendum.

U.S. Equity Valuations: To Be Dismissed?

History shows that valuations don’t matter until they do. The challenge is gauging what will cause investors to balk at current multiples, which have vaulted to elevated levels.

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Monetary policy uncertainty is a potential candidate: reduced domestic liquidity would force profits, which have entered a difficult phase, to become the primary driver of capital appreciation.
A dearth of pricing power, rising wage expenses and a strong U.S. dollar together put a serious dent in earnings growth projections. The strong dollar on its own is a tactical valuation warning. The narrowing yield curve is another signal that the market is not comfortable with the Fed’s judgment that the economy can handle and even needs higher interest rates, another threat to valuations.
A number of other factors could still cause valuations to reset. Economic data is undershooting expectations in the U.S., even though momentum has picked up abroad. This reinforces that foreign QE programs are redistributing growth via currency weakness rather than lifting global final demand in aggregate. The forward P/E and economic surprises have also trended together since the Great Recession.
The market has ignored the recent downturn in inflation expectations. The latter is an excellent indication for S&P 500 sales, and by extension, corporate profit growth. The gap that existed since 2013 can be explained by QE, i.e. investors were content to overlook deflation threats because the liquidity taps were still gushing. But now that the Fed is telegraphing a path to tighten, it is possible that the gap will close.

QEs And EM: A Love-Hate Story

Has quantitative easing (QE) among developed nations’ central banks benefited emerging markets (EM)? While it seems very intuitive to answer “yes,” our EM strategists believe the interaction between G7 QEs and EM financial markets and economies has been much more complicated. In fact, this relationship resembles a love-hate story.

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On one hand, G7 QEs has depressed yields on their local domestic fixed-income securities, encouraging global investors’ “love” toward EM. Consequently, substantial capital has flown from the G7 into EM. On the other hand, EM risk assets – stocks, currencies and credit markets – have performed very poorly, despite ongoing and rotating QEs within the advanced countries.

Many investors have been disappointed by EM’s broad-based poor performance. As for EM policymakers, back in 2009-’10 they struggled to contain massive portfolio inflows. Now, a number of them are struggling with outflows. Both issues – investors’ disappointments with EM asset performance and EM policymakers’ travails managing the torrential inflows/outflows – reflect the “hate” aspect of the interactions between QEs and EM.

The reason why EM risk assets have done poorly despite the ongoing QEs is their indigent fundamentals in general and sharply deteriorated return on capital. Capital inflows related to QE led to overinvestment and mal-investment in EM, which is now weighing on profitability.

By and large, odds are low that the ECB’s QE will be very different from the previous QEs with respect to its impact on EM; it could produce short-term bounces in EM, but the cyclical outlook for EM risk assets remains downbeat.