The conversations at Davos tend to be dominated by the contemporary. This year, the European Central Bank’s announcement of quantitative easing quickly became the consuming topic at the World Economic Forum’s Annual Meeting. While I view this as arguably the most monumental event in the history of the European Union, the question remains whether it will be enough to stimulate Europe’s flagging economy.
The ECB plans to purchase 60 billion euros’ worth of a combination of government bonds, debt securities issued by European institutions, and private-sector bonds, each month from March until at least September 2016. The ECB seems to be hanging its hat on the expectation that this action is going to increase inflation, which will translate into job growth, which will in turn stimulate the economy. I’m not so sure that is the transmission mechanism. I think the real transmission mechanism will be if the ECB is able to introduce enough liquidity into the system to drive up asset prices, and through the process of driving up asset prices, drive interest rates down further. This would reduce borrowing costs for businesses, which would improve profitability and encourage them to hire more workers.
In addition to that, we would also get the wealth effect. In Europe, the wealth effect is not nearly as profound as it is in the United States, but that was the blunt instrument upon which former Federal Reserve Chairman Ben Bernanke relied. It would take a lot to make it work in Europe, but it is possible.
If the ECB is successful, the result will be growing confidence in Europe’s economy. Much of the additional liquidity will leak out into other markets around the world, especially the United States, and we could see equity prices, both in Europe and the United States, move meaningfully higher. We could also see interest rates in Europe and the United States rise significantly in the second half of the year as the market gains confidence that all of this liquidity is leading to stronger economic growth.
Meanwhile, the Federal Reserve is getting itself locked into the idea that it needs to do something by the third quarter. The problem is that many of the macro factors the Fed has been leaning on aren’t falling into place, which could force the Fed to delay any rate adjustment.
My guess is that we’re going to get some sort of rate increase in late 2015, which will probably signal a meaningful increase in interest rates in the United States. Ultimately, the long end of the curve could probably move up another 100-125 basis points.
I don’t think all this will happen this year, but as the market re-prices for stronger growth and a rising Fed funds rate later this year it is likely to signal the beginning of a bear market for interest rates. For fixed-income investors, now is the time to focus on floating-rate securities and to actively manage duration.
Chart of the Week
Euro Zone Wealth Effect Likely Less than U.S.
One of the key channels by which quantitative easing works is through the wealth effect. With the central bank suppressing interest rates, investors are pushed into riskier assets, lifting the value of those assets. This, in turn, makes households feel wealthier, encouraging individual spenders to increase consumption. For U.S. households during the Fed’s rounds of quantitative easing, this was a relatively straightforward process. Individual investors in the U.S. hold a larger majority of their household financial assets in instruments—such as stocks, bonds and mutual fund shares—that benefit from rising financial markets. In the euro zone, in contrast, currency and deposits account for more than a third of assets—about twice as much as in the U.S. With fewer risk assets and more deposits, we estimate that the wealth effect on consumption in Europe is about 40 percent less than it is in the U.S.
Source: Haver, ECB, Guggenheim Investments. Data as of 3Q2014 for the U.S.,1Q2014 for the euro zone.
Economic Data Releases
U.S. Housing Data Mixed
- Existing home sales rose 2.4 percent in December to an annualized pace of 5.04 million homes. Housing inventory fell by 11.1 percent from December, putting the month’s supply figure at a post-recession low.
- Housing starts were better than expected in December, rising 4.4 percent to 1.089 million. Single family starts were up while multifamily starts declined.
- Building permits fell in December for a second consecutive month, down 1.9 percent to 1.032 million.
- The NAHB Housing Market Index fell in January, ticking down to 57 from 58.
- The FHFA House Price Index expanded by the most in 11 months in November, rising 0.8 percent from the previous month.
- Initial jobless claims fell by 10,000 for the week ending Jan. 17, down to 307,000.
- The Leading Economic Index rose 0.5 percent in December, with eight out of 10 indicators positive.
Euro Zone Data Improves, China’s Growth Slows
- Euro zone consumer confidence improved in January, rising to a six-month high of -8.5.
- The euro zone manufacturing Purchasing Managers Index rose in line with expectations at 51.0, a six-month high. The services PMI also rose to 52.3.
- Germany’s manufacturing PMI weakened in January, but remained in expansion at 51.0. The services PMI rose for the first time since September.
- The ZEW survey in Germany was well above forecasts in January, with the current situation index at a four-month high of 22.4 and expectations at an 11-month high.
- The manufacturing PMI in France beat expectations in January, rising to 49.5, the highest since last May, but the services PMI fell into contraction.
- U.K. retail sales were up 0.4 percent in December, the third straight increase.
- China’s fourth quarter GDP was above expectations at 7.3 percent, putting the full year growth rate at 7.4 percent, the lowest since 1990.
- Industrial production in China accelerated in December, with the growth rate rising to a three-month high of 7.9 percent year-over-year.
- China’s HSBC manufacturing PMI had a small rebound in January, ticking up to 49.8 from 49.6.
- Chinese retail sales growth increased for a second consecutive month in December, rising 11.9 percent.
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