Almost two years ago, the president of the European Central Bank (ECB), Mario Draghi, pledged to do “whatever it takes” to save the euro. This pledge was backed and made credible by the ECB’s Outright Monetary Transactions (OMT) program, under which the Bank would purchase in secondary sovereign bond markets the bonds issued by Eurozone member states, with the objective of “safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy.” This program is not the equivalent of the quantitative easing practiced by the Federal Reserve and the Bank of Japan, which involves buying bonds in order to inject liquidity into the banking system. In the case of the OMT, the ECB would reabsorb the additional liquidity (full sterilization). The bond purchases would be expected to reduce long-term interest rates to more viable levels for countries experiencing external financing problems.
Draghi’s pledge and the existence of the OMT have had the desired effect of defusing the euro crisis, greatly reducing fears of a financial contagion leading to the break-up of the Eurozone. It has not been necessary to date for the ECB to activate this program, and it may never be necessary. However, until last week there remained a cloud over the ECB’s ability to stabilize the Eurozone should strains arise in the future. Germany’s constitutional court made clear its strong doubts about the legality of the OMT, which it believes exceeds the ECB’s mandate. In several months it was due to issue a decision on this matter which could have called into question the ECB’s ability to head off a future crisis that might threaten Europe’s monetary union.
The “good news” last week was the referral of the matter by Germany’s Supreme Court to the European Court of Justice (ECJ). It is unlikely that the ECJ, after several months of deliberations, will rule against this key policy of the ECB. That anticipated outcome will not completely settle the issue, as the German court and a significant number of German taxpayers will likely remain highly skeptical.
The ECB naturally welcomed the unexpected move by the constitutional court. Financial markets also responded positively to this perceived reduction in a tail risk for Europe and the euro. European equity markets had already been benefiting this year as a result of the outflows of investment funds from emerging markets. The region’s equity markets are widely viewed as having attractive prospects in 2014. While the pace of the economic recovery remains tepid, the move from recession to positive growth, the progress that has been made in increasing international competitiveness and other economic reforms, the reduced fiscal drag in most economies, and the relative attractiveness of valuations that were not run up as much as those in the US last year all combine to make a strong case for European equities in 2014.
We share this positive assessment. The main remaining risk that concerns us is the continued edging down of inflation in the Eurozone, registering only 0.7 percent in January, well below the ECB’s target of a little below 2 percent. This disinflationary trend is getting dangerously close to actual deflation (falling prices). Deflation would raise real debt burdens, a serious concern for the weaker member countries. On Thursday the ECB failed to take any action to counter this risk. Draghi stated in his press conference that “There is certainly going to be subdued inflation, low inflation for an extended, protracted period of time, but no deflation.” He also stated the need to acquire more information before acting. Should inflation continue to attenuate in February, it seems likely that the ECB would decide at its next meeting in March to take some action, possibly a rate reduction and or a measure to increase liquidity. We will be watching this matter closely. We are not as confident as the ECB currently appears to be that deflation can be avoided without further policy action.
Thus far this year European markets have been caught in the general downdraft in global equity markets. According to the MSCI equity markets indices, the All Country World Index (ACWI) is down 3.34% year-to-date as of the end of last week. The All Country Ex US Index (ACWX) is down 3.95%. Europe is down a little less, -2.19%. Thus far in February, global and European markets have turned back up (ACWI +0.76%, ACWX +0.7%, Europe +1.72%). We do not know whether the market adjustment is truly over and so are maintaining some cash in accounts. It is noteworthy that some European markets have not participated in the declines this year, with Denmark and Ireland each up over 8% YTD, Italy up 2.89%, and Spain and Switzerland up about 0.4%. Selecting carefully among European markets continues to be important for adding value to portfolios.