Back in 2012 Mario Draghi, the head of the European Central Bank (ECB), lit a fuse under global share markets by declaring the ECB would do “whatever it takes” to support the Eurozone. Since then he managed to buy a lot of time largely by talking about taking action. In January things caught up and with chronic deflation threatening the Eurozone the ECB had to play the shock and awe card, announcing an unexpectedly large Quantitative Easing (QE) program to inject more cash into circulation in the hope of reviving inflation.
The world is now fairly familiar with QE, given the US started it off some six years ago and since then the UK and Japan have followed suit. But the ECB’s strategy has been controversial and a long time coming because the Germans have long memories and are opposed to anything that resembles the disastrous money printing of the Weimar Republic plus they see it as reducing the incentive for the many underperforming countries within the Eurozone to do the hard work required to get their houses in order.
Draghi announced the ECB will increase its balance sheet by more than €1 trillion by purchasing €60bn worth of a variety of different bonds every month until inflation is back at a satisfactory level. It was designed as a knock out blow and markets, especially in Europe, celebrated with a healthy rally with the Stoxx600 up 7.6% for the month! The chart below shows the ECB has undertaken forms of QE in the last few years, but the balance sheet has been allowed to run down again and compared to the Fed its stimulus program was far less consistent.
Balance sheet of the US Fed compared to the ECB
Source: Bloomberg, AMP Capital
Will it work? Everybody hopes so, but nobody knows for sure. The contribution that QE made to putting the US economy back on a growth path will always be debated, because the simple fact is we have no idea what would have happened without QE. Asset markets, such as shares, property and bonds have done very well, but that too is controversial because while it’s great for the (usually wealthy) people who own those assets it’s unclear what benefit it has for the real economy on which the vast majority of people rely for a job that pays a decent wage. The ECB will be buying bonds at already record low yields (and therefore record high prices) and the appetite for borrowing the newly available money remains very low at a corporate, household and personal level. It’s far from clear whether QE will change that. The U.S. bond market is a lot bigger than Europe’s, where companies have traditionally relied more on bank lending to source capital. Finally, as much as the EU was designed to foster harmony between countries that had been at war with one another for thousands of years, massive structural differences still remain at an economic level, differences that no other country that has undertaken QE has had to deal with.
European shares are cheap
Source: Bloomberg, AMP Capital
We have been overweight European shares for a while, and the chart above helps show why. On a long-term basis, they are cheap and with further downward pressure on bond yields, shares will likely benefit from those seeking a return – any return – on their investable funds.
Euro/US$ exchange rate
One thing QE has already changed is the currency. The Euro is trading at record lows against many of its trading partners (see the chart above) which makes European exports more competitive. There have been more than 500 monetary easings by central banks around the world in just the last three years, with many of them at least partly aimed at making their exports more competitive. In a low growth, low inflation environment a currency war is a potentially ugly, but perhaps inevitable, outcome.
The Swiss National Bank also hit the headlines this month after it realized, like King Canute and the tide, that trying to hold back market forces was doomed to failure. The Swiss announced in 2011 they would peg the value of the Swiss Franc at 1.2 to the Euro. The problem is, in a world where investors are awash with money and seeking safe places to put it, the Swiss Franc was an obvious popular choice. Switzerland enjoys a healthy current account surplus, a balanced fiscal budget and a sophisticated financial sector – not exactly common amongst its continental neighbors.
Euro/Swiss Franc exchange rate
The SNB was already struggling to buy enough foreign currencies to keep theirs at an artificially low level and with the ECB about to announce QE they finally gave in and let the franc float. Initially it rose an astonishing 32% against the Euro (see the chart above)! Despite cutting rates to be negative as a disincentive for investors to buy the franc, they just kept coming. Right now if you want to lend the Swiss government money for ten years, you have to pay them 0.32% p.a. for the privilege. A radical currency move like that will wreak havoc on Swiss exporters – those fancy watches have just got even more expensive – which will in turn affect economic growth. A casualty of the currency war.
The SNB was called some nasty names by various market ‘experts’: irresponsible, silly, dusted their credibility. You can bet those people were the ones who thought Canute was odds on to beat the tide. The interesting thing is, the story of Canute was actually the good king showing his overly-loyal subjects that humans are fallible and not even a king can command something that is subject to a greater power. Much like what the SNB might say to its critics.
While we’re looking at Europe the other development there in the last month was Syriza, the far left party in Greece, which campaigned on abandoning austerity and repudiating Greece’s debts, won the national election. The new 40 year old Prime Minister Tsipras is on a collision course with the EU and the ECB, raising the possibility that Greece will be forced to leave the Eurozone. While that was once considered potentially catastrophic, one of the benefits of the ECB’s buying time over the past few years is that it has had the chance to put mechanisms in place to help cope with a country like Greece leaving the Eurozone. Whilst it would be a test, it’s unlikely to be a catastrophe.
China’s December 2014 quarterly GDP growth was 7.3%, an amazing number (if you can believe it). However, as markets are prone to do it fixated on the fact it was the slowest rate of economic growth in 24 years and the first time in ages the number came in less than the government’s target of 7.5%. Before we get too excited, it’s worth noting the Chinese economy is about 15 times the size it was 24 years ago, and the government has been saying for some time they want to change the composition of economic growth from ‘shipping to shopping’. Part of that plan has been the steady reduction in the amount of growth coming from Fixed Asset Investment (FAI) – government spending on infrastructure. At one point FAI was around a globally unprecedented 40% of GDP, now it’s come down to 15.7% (see the chart below), which is a good sign.
FAI is declining as a proportion of the Chinese economy
Source: Deutsche Bank, WIND, CEIC
A consequence of the changing composition of Chinese growth is a slowing in the rate of growth in commodities demand. Absolute demand is still enormous; in fact China’s iron ore imports last year grew by a record 13.8%, or more than 930m tonnes, of which Australian accounted for 59%. But the iron ore price halved last year because the rate of growth in demand slowed. That has affected commodities prices across the board, and throw in the shenanigans in the oil market as the Saudis put the squeeze on the high cost producers, and the Bloomberg Commodities Index is trading at its lowest since 2002 (see the chart below).
Bloomberg Commodities Index 2002-2015
Interestingly, the U.S. share market experienced a dramatic month, with volatility picking up to be near its 10 year average: almost half the S&P500’s trading days were a 1% move or more. Yet nothing particularly dramatic happened in the U.S. during the month: it continues to glide toward recovery with a steady, though not remarkable, 2.4% GDP growth for the year, and the 30 year bond hit another record low yield. With unemployment falling to 5.6%, 2014 was confirmed as the best year for employment growth in 15 years, which was reflected in small business and consumer optimism reaching their highest levels in eight years (see the chart below).
Business and consumer confidence back to long-term averages
Source: NFIX, U of M, Haver Analytics and Deutsche Bank
The Australian share market got a big boost when a noted Reserve Bank watcher wrote an article saying the RBA will cut interest rates in February on the back of dramatic revisions to their growth and inflation forecasts. If they do, it will have been a tough decision. Australia already has 50 year low rates and credit growth was shown to be running at 5.9% p.a. in December. The key is, the housing market accounted for a big chunk of that, driven by a 10.1% increase in lending to buy investment properties, taking it to a record 51% of new mortgages. Meanwhile, lending to first home buyers is the lowest since December 2004 (see the chart below). APRA, the regulatory authority that oversees the Australian banking system, has been rattling its cage saying ominous things about too much lending to investors unbalancing the market and threatening prudential lending controls, that is, imposing restrictions on who banks can lend to, how much and for what purpose.
Australian housing loan approvals
In addition, Australia’s unemployment in December came out surprisingly low at 6.1% with job ads recording their seventh consecutive monthly gain, a rise of 11.4% over the year. Even the A$ is playing in to the RBA’s hands, closing the month not far off the its target of U.S.$0.75. The fly in the ointment, as it is in so many parts of the world right now, was the lowest quarterly inflation reading in three years at an annual 1.7%. But with the oil price falling 50% last year, perhaps that shouldn’t have surprised anyone.
The good stuff
Scientists have discovered the first new antibiotic in nearly 30 years by taking a different approach to growing uncultured bacteria. The team of scientists has collected some 50,000 strains of bacteria and discovered 25 new antibiotics, of which teixobactin is the most promising. It’s been found to treat many common bacterial infections without any signs of resistance, giving hope in the fight against drug-resistant super bugs. Human trials are expected to start in about two years.