ECB: looking for an exit?

Market analysis - 11/3/2016

Financial Column by Jean-Charles Schiltz, Chief Investment Officer, Edmond de Rothschild (Europe).

Following the ECB governing council’s decision to maintain the status quo, the markets are still waiting to hear fresh announcements at upcoming monetary policy meetings. Although dismissed for the time being by ECB president Mario Draghi, the question of whether the proverbial “tapering” will take place remains unanswered.

Indeed, the ECB will have to look for an exit sooner or later. Rumour has it that the central bank is considering adjusting its quantitative easing policy, for example by gradually reducing the amount of its bond purchases – the much-discussed tapering – in increments of EUR 10 billion per month. According to “ECB officials” quoted by Bloomberg at the beginning of October, this would not initially rule out the possibility of the programme being extended past March 2017.

Testing the waters

Reduction? Extension? At the very least, these subtleties confirm the uncertainty that still prevails within the central bank surrounding the sustainability and relevant effects of this highly accommodative European monetary policy. You may recall that these unconventional purchases, already used in the United States and Japan with questionable results, were the source of much controversy in Frankfurt prior to their launch in March 2015.

This expansionary policy, which is a long way from being proven effective, certainly produces tangible effects – particularly on property and the bond markets. According to an ECB survey of commercial banks, mortgage demand growth is at its strongest level since 2003. Growth is substantial throughout the eurozone, and is particularly strong in Germany and Spain. For some, this will bring back bad memories.

Glaring anomalies

But the ECB and the other major central banks, which are now advocates of quantitative easing (QE), have thus artificially inflated and distorted the price of certain real and financial assets.

Let us look at some of the most glaring anomalies. More than EUR 10,000 billion in debt is currently being traded worldwide with negative yields, including that issued by private businesses. Last month, Sanofi and Henkel issued bonds with yields of less than 0%. While it would have been foolish of these issuers to not seize this golden opportunity, it makes little sense for investors, as they are supposed to at least be compensated for the risk of default.

While QE weakens the banking sector by squeezing credit margins, it also produces other adverse effects. In the United States, the same policy (which is currently on hold) and interest rate compression led companies to take on cheap debt to buy back their shares and increase their dividends rather than investing. These practices have shored up stock market prices and inflated earnings per share.

Skewed valuations

In the eurozone, where the underutilisation of production capacity is also hardly conducive to increased investment, we might well fear the same kind of behaviour. Moreover, equity valuation methods founded on discount rates are skewed by risk-free rates being at zero. Finally, this policy may encourage eurozone governments to put off the structural reforms that should really be tackled head-on to increase productivity and improve growth prospects, which are severely lacking in the eurozone.

Markets more vulnerable

This tapering must therefore take place in the not too distant future, even though there doesn’t appear to be an immediate risk in light of the ECB’s recent official statements. It is difficult at this point to gauge the ramifications, given the highly uncertain times ahead. The curve ball delivered by Bloomberg’s breaking news caused a backlash among bond yields. The German 10-year Bund yield, which is also sensitive to the possibility of a Fed rate hike in December, is back in positive territory. There can be little doubt that the start of a withdrawal by the ECB would render both financial and non-financial assets more vulnerable.