Draghi Crosses the Rubicon while Juncker Peddles "Europhemisms"
The announcement by newly installed European Commission President Jean-Claude Juncker of a package designed to secure €315 billion of investment for the eurozone garnered a lot of press interest in late November. However, John Beck, director of Fixed Income, London, and portfolio manager, Franklin Templeton Fixed Income Group®, believes a speech by European Central Bank (ECB) President Mario Draghi at a bankers’ conference in Frankfurt earlier in the month offers more practical insight for investors. Here he outlines lessons to take from Draghi’s speech in the lion’s den.
Director of Fixed Income, London
Senior Vice President, Portfolio Manager, Franklin Global Government Bond Fund
Franklin Templeton Fixed Income Group®
On the face of it, the €315 billion investment plan unveiled on the 26th of November by European Commission President Jean-Claude Juncker1 may look impressive, but when you consider that it represents less than 3% of the eurozone GDP, it’s perhaps not that exciting. Equally when you look at the specifics, the European authorities, through the European Investment Bank (EIB), are putting up just €16 billion, and they are hoping that the private sector is going to come in and supply the rest. That’s not going to transform the world, in my view.
Even considering that these EIB-sponsored funds may be eligible for the European Central Bank (ECB) to buy as part of its asset-buying project that it hopes will drive increased liquidity across the eurozone, I don’t think this is anything close to a revolutionary approach. I think it shows how hesistant different parts of the eurozone are in terms of trying something different.
Juncker’s announcement was packed with what I call “europhemisms”—meaningless euphemisms expressly designed not to offend any constituent of the European Union—such as “adding a third point to the virtuous circle,” “applying the jump cables” and “turning the page.”2 But if Juncker is “turning the page,” a few days earlier, right in the seat of monetary rectitude—the European Banking Congress in Frankfurt—ECB President Mario Draghi crossed the Rubicon and admitted the ECB has opened the door to quantitative easing. He told the audience of European bankers: “We resorted to asset purchase. Faced with continuously weak inflation, we reached the effective lower bound on our policy interest rates, and we resorted to asset purchases as a means to expand further our monetary policy stance.”3 This is a pretty powerful place for Draghi to be opening this conversation, in my view.
Draghi went on to say that inflation has been too low and was affecting the future inflation outlook. As a result, he insisted it was essential the ECB has acted to bring inflation back toward 2% and ensure the firm underpinning of inflation expectations.4 Some observers would say he has been slow to make these decisions. There has been an internal debate within the ECB on whether to buy sovereign bonds, when to buy them, and what the break-down of the bonds they might buy should be. I think now we’re beginning to get some answers.
Japan is also attempting to counter what it sees as low inflation. Its central bank, the Bank of Japan, has an explicit inflation target: it is now trying to generate 2% inflation.5 In his recent speech, it seems to me that Draghi is reiterating, implicitly rather than explicitly, the fact that the ECB has a similar target. And in effect he is saying that, if the European authorities can’t get inflation up to that level quickly, they are going to have to do more—basically, they seem to be opening the door to formal sovereign buying in the secondary markets.
On the one hand, I think Draghi is careful to say all the right things about not letting inflation get out of control, but on the other hand, he concludes—and this is incredibly powerful: “If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases.”6
So I think what the ECB is proposing in terms of monetary policy should be a great deal more effective than the European Commission essentially providing €16 billion worth of capital and hoping that someone else is going to borrow the rest. In my view, that’s far from the application of jump cables that Juncker promised.
When you talk about “jump cables”—or when you defibrillate a patient—you deliberately stand away because you’re giving a real shock. I don’t think €16 billion is a real shock. I think what Mario Draghi is proposing has the potential to be much more transformative in terms of what the outcome could be from a European growth perspective.
Portfolio Balance Effect
The ECB is now talking about portfolio balance effect—the concept that, if a central bank buys up lower risk sovereign instruments, investors will likely move into riskier assets. This concept, to me, is very important.
In his speech on November 21, Draghi explained:
“As we buy assets, investors are likely to substitute the lower-risk assets we buy with riskier assets such as longer-term assets, equities and possibly real estate. This type of move has well-known effects on interest rates across the curve, on the cost of capital, on wealth—through higher equity and real estate prices—and therefore on balance sheets more generally.
“There are certainly question marks as how strong these effects are in the euro area. We do not have precedents and therefore empirical data for an economy such as ours, which has a different financial structure from the United States or Japan. But there is no question as to the sign of the effects—it is clearly positive.”7
In so many words, I think this shows Draghi is likely telling us that the ECB is planning to do what the Bank of Japan and what the US Federal Reserve have done, in terms of quantitative easing.
And by acknowledging that substitution of assets can also take place across jurisdictions, “which would take the form of investors rebalancing portfolios away from euro-denominated assets towards other jurisdictions and currencies providing higher yields,”8 Draghi appears to be saying that, if the euro weakens, which is the likely effect of portfolio rebalancing, he’s happy with that outcome. A weak currency is generally good for growth because a country can export more.
The slight concern, in my view, has to be whether the ECB will achieve the weakening of the euro because the eurozone still has a very large current account surplus.
I do think the euro has the capacity to weaken further, but the flip side is the United States’ tolerance to shoulder the burden of global economic recovery, and it remains a question mark.
The lesson from Draghi’s speech, I believe, is “listen to what you’re being told.”
And what I interpret from his remarks is that investors might continue to be overweight periphery, continue to expect the yield curve to flatten, and anticipate sovereign buying in the first quarter of next year. My expectation is that sovereign buying will likely be based on the percentage allocations of capital paid into the ECB, which could mean that countries like France, Spain and Italy could very likely be large beneficiaries of that buying.
In summary I feel that when the head of the ECB makes a speech in Frankfurt—the “temple” of central banking—it’s incumbent on those of us who work in the markets to listen to his sermon and draw our own conclusions. Others might draw different conclusions, and that’s the power of active management.
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