We will take decisive action. Well, ECB president Mario Draghi certainly delivered during the most recent monetary meeting by the European Central Bank. After long communicating the message that the central ‘stands ready to act’, a package of additional measures was announced on Thursday March 10. Next to cutting the refinancing rate to 0.0%, the deposit rate to -0.4%, the ECB expands the monthly purchases under the asset purchase program (APP, or QE) with EUR 20 billion to EUR 80bn (USD 72bn). Interestingly, the central bank now includes bonds issued by non-financial corporates. To conclude the package, a new series of targeted longer-term refinancing operations (TLTRO II) will be launched.
But what will this all bring for the markets? Will it boost share prices so that we can escape a bear market?
More QE than expected, but will share prices rally?
The package announced by Draghi beat market participants’ estimates. Most had expected a maximum expansion by EUR 15bn. Also the inclusion of corporate bonds came as a pleasant surprise. As a result, European shares soared shortly after the announcement. The EUR/USD exchange rate dropped sharply (i.e. Euro weakened) and bonds rose significantly, pushing yields lower. But during the afternoon, this move was suddenly reversed as investors were worried by comments by Draghi during the press conference hinting that further cuts will be unlikely. A day later, worries faded and markets rallied, also helped by strong bank results.
But why should investors cherish the additional measures? After all, 12 months after the launch of the APP, European stocks are down by roughly 15% (Eurostoxx50, in EUR), so one could argue whether stock investors are helped by the easing. Adding EUR 20 billion more doesn’t look like a major boost to turn this around. Moreover, analysts expect that only EUR 5-10bn can be attributed monthly towards corporate debt.
In theory, the ECB buying corporate debt would mean that yields will decline. The ECB calculated that the European corporate bond market is roughly EUR 900 billion in size. Analysts of Deutsche Bank calculated that roughly EUR 420 billion could be eligible under the expanded program. To remind you, in December the ECB announced that the QE will be extended until the end of March 2017. The start of corporate debt purchases will start no sooner than the end of the second quarter, so July will probably be the first full month. 9 months of purchases adds to a sum of EUR 45-90bn in corporate debt, so that will likely have a material effect on corporate yields.
When corporate yields will come down, this helps stocks in two ways. First, corporates can issue debt at lower costs. That makes it more attractive to adjust balances and debt may be even issued to buy back shares, as we saw on a large scale during the recent years, in particular on the US market. Secondly, lower corporate bond yields will drive investors towards the equity markets, most likely towards dividend paying firms. That could push share prices higher. So somewhat enthusiasm for the expanded program by investors is fully explainable.
Can TLTROII bring an impulse?
Maybe the TLTROII announcement is even more interesting. As we noted earlier, investors are worried about a default cycle. Bank shares were hit hard during January and the first weeks of February due to concerns about their profitability. The TLTROII program could bring relief for the banks in the Eurozone. This program is constructed to provide banks with cheap financing for their lending operations. Cheap? Actually free financing or even with a bonus! Banks may pay only the deposit rate when they lend to non-financial corporates and households (excluding for purchasing houses). And the deposit rate is a negative 0.4%, so the banks will actually receive funds for lending towards the economy!
This helps in two ways: banks can improve their margins and they receive a significant incentive to lend to corporates and households. Margins on loans towards corporates, especially small- and medium enterprises, and households is still relatively high. Banks are less tempted to use financing for ‘other’ activities, such as the famous Sarkozy-trade (banks buying government debt).
But there’s one catch: this only works if there’s demand for loans. And a large number of analysts argue that demand is shrinking. Some point to the process of global de-leveraging. Since the ECB’s program is not introduced because of a strong economy, businesses and households may view this as a sign of a harsh future. With gloomy future prospects, demand for loans will suffer.
ECB helps, but can’t take away uncertainty for investors
All in all, the freshly announced measures by the ECB look promising. But it is hardly a guarantee for a new bull run. The recent 12 months teach investors to remain skeptical of a short term rally. As we’ve argued, the problems for commodity-exporting countries and the slowdown in China are a strong force. We still don’t know the impact of low oil prices and defaults in the energy sector. Oil prices have recovered lately, but are still at stressed levels. So worries regarding a default cycle may return. Sovereign wealth funds and China won’t return as strong buyers of bonds. Quantitative tightening could still play a role. Let’s see if the ECB’s additional measures can ease the pain and safe us from a bear market…