The European Central Bank (ECB) followed through with the central bank’s Resident Mario Draghi’s promise last month that the Bank would act decisively at their June meeting to counter the threat of deflation. At that time the most recent rate of inflation for the Eurozone was 0.7%. Today that rate is 0.5%. Further pressure on the ECB to act came from the May Eurozone Purchasing Manager Index (PMI) for manufacturing, which indicated a modest slowdown – 52.2 versus 53.4 in April. The composite PMI, which includes services as well as manufacturing, was also down, 53.5 versus 54.0. While these measures are consistent with positive economic growth for the quarter, the region’s advance remains uneven and lackluster. After a one percent decline following the previous ECB meeting, the euro/dollar has remained stuck in the region of 1.36, too high in the view of European policymakers.
As widely expected, the ECB decided to cut policy interest rates, which were already very close to the zero bound. The repo rate, which was at 0.25%, was reduced by 10 basis points to 0.15%. A more radical move was the introduction of a negative deposit rate for funds banks deposit with the central bank. Formerly at 0.0%, it is now set at -0.10%. That move is intended to provide an incentive for banks to loan their excess funds into the economy rather than depositing them with the central bank. This move, unprecedented for a major central bank, will be relevant mainly for the large banks in the core Eurozone economies. As those banks have already reduced their central bank deposits significantly, this small 10 basis points move from zero to a negative deposit rate will not likely have a large effect on bank lending.
Of greater interest to the markets were the further the additional measures “to provide monetary policy accommodation and to support lending to the real economy” announced by Draghi at his press conference. Highly anticipated was the new “targeted” LTRO (long-term refinancing operation) facility that is directed at providing up to 400 billion euros to banks to lend on to the nonfinancial private sector. Also, the ECB will suspend the sterilization of the bond purchases that it made at the start of the euro crisis, an important move that will add liquidity to the economy. Particularly welcome to markets was the announcement that work will begin on purchases by the ECB of asset-backed securities, a move that will help foster a market in securitized lending in Europe. Development of that market is needed for lending to small and medium-sized enterprises.
The fully anticipated limited interest rate reductions by themselves are not likely have a significant effect on the European economy and the course of inflation. However, when taken together with the package of measures noted above, which exceeds the expectations of many observers, the overall impact could well be substantial. We were anticipating that economic growth for the year 2014 would be only 1.2%, which implies a very modest quickening in the pace of economic activity during the remainder of the year. These new measures may raise that growth to 1.4% for the year. The threat of deflation for the Eurozone as a whole has been reduced.
There are considerable differences in momentum among the major economies in the zone. As indicated by the latest PMI data, continued strong output and jobs growth were reported for the largest economy, Germany, and also for Spain. Output and jobs also advanced in Italy. In marked contrast, the French economy fell back into contraction in May and reported further job cuts. New orders at French manufacturers reflected weak demand both domestically and abroad. GDP growth for France, the second largest economy in the Eurozone, is projected to be only 0.7% this year, in contrast to the 2.0% growth projected for Germany.
Eurozone equity markets have only recently begun to reflect the differing performances of the German and French economies. The year-to-date return for iShares MSCI Germany ETF (ARCA:EWG) is only 0.63%, compared with 5.58% for the iShares MSCI France (ARCA:EWQ). But the one-month return for EWG is 1.59%, rather better than 0.2% one-month return for EWQ.
The equity markets of Spain and Italy, which had been more depressed than those of the two largest Eurozone economies, have recovered more strongly, reflecting substantial reform efforts in both countries. The year-to-date return for the iShares MSCI Italy Capped Fund (ARCA:EWI) is 13.34, even after a 1.61% pullback over the preceding month. The iShares MSCI Spain (ARCA:EWP) performed almost as strongly, with a 10.3% year-to-date return, including a 1.36% gain during the previous month.
Our International and Global Equity ETF portfolios are moderately underweight for Europe. Within the Eurozone our preference is for Germany and Spain. Outside of the Eurozone we continue to have positions in the UK and Sweden. The immediate reaction of the euro was to weaken down close to 1.35 versus the dollar but rather quickly that drop was erased. We may be seeing the tendency to “sell the rumor, buy the news”. We continue to expect some weakening of the euro versus the US dollar in the second half. Accordingly, we are maintaining our position in the WisdomTree Intl Hedged Equity Fund (NYSE:HEDJ), which includes a hedge against changes in the euro/US dollar exchange rate.
Bill Witherell, Chief Global Economist