The ECB Is Ready To Act - Will It Be Effective?

At his monthly press conference last week, Mario Draghi, President of the European Central Bank (ECB), stated that while the ECB did not change its benchmark interest rates, “the governing council is comfortable acting next time.” He noted there was consensus over “dissatisfaction about the projected path of inflation.” Inflation in the eurozone is only 0.7%, well below the ECB’s target of close to 2%. Unless there is a data surprise, the ECB is likely to act to counter the threat of deflation at their June meeting.

Pressure for the ECB to loosen its monetary policy has been mounting. The IMF in its recent World Economic Outlook states that “more monetary easing, including use of unconventional measures, is needed now. The current baseline projections imply that inflation will undershoot the ECB’s price stability target by substantial margins for much longer than the usual horizon of one to two years. In this context, there are important risks that inflation will turn out even lower than forecast. Inflation expectations may drift lower…. This in turn would lead to higher real interest rates, aggravate the debt burden, and lower growth.” The Organization for Economic Cooperation and Development (OECD) has stated similar concerns and recommends that “monetary policy needs to remain accommodative, especially in the euro area, where a further interest rate reduction is merited.”

Within the eurozone, France’s government has been particularly outspoken, centering its concerns about the strength of the euro and the negative effects of a strong euro on exports and economic growth. Actually economic growth in the eurozone, while still modest, has been accelerating, even in the weaker economies on the periphery of the zone. Nevertheless, unless economic data proves significantly stronger in the next several weeks, the ECB looks very likely to move at its June meeting.

No indications were given by Mr. Draghi as to what policy measures the ECB might choose. Most likely are modest options: reducing the benchmark refinancing rate, which now stands at 0.25%, for instance, and reducing the rate paid by the ECB on deposits by banks to below zero – in effect charging the banks for holding their deposits. Less likely would be some form of quantitative easing, the course followed by the central banks of the US, Japan, and the UK. While opposition within the EC to quantitative easing appears to have lessened, Draghi is unlikely to turn to this more extreme measure until he has first tried more conventional measures.

However, if the ECB does limit its actions in June to the rate-reduction measures noted above, it is uncertain as to whether they will have the desired effect on boosting inflation and putting downward pressure on the euro. That said, Draghi’s press conference statement has already had a negative effect on the euro. The euro/US dollar rate, which was flirting with 1.40 today, is at 1.37 as this is written. The modest rate cuts we are anticipating may already be largely priced into the market. Further weakening of the euro may well require more aggressive action in June, or at least statements that make clear the ECB’s intention to take further action if needed. It most likely will be needed.

We do not know how far the euro/US dollar exchange rate is likely to depreciate. Many factors interact to determine bilateral exchange rates. Our view of the increased likelihood of euro depreciation vs. the US dollar in the coming months has led us, in our International and Global portfolios, to add a position in the WisdomTree Europe Hedged Equity ETF, HEDJ, which invests in European companies with significant revenue from exports and includes a hedge against changes in the euro/US dollar exchange rate.

Any easing in the euro exchange rate would be welcomed by eurozone exporters and would add some needed momentum to the ongoing economic recovery in the region. The eurozone’s economic growth now looks like averaging 1.4%, less than the 2.5% for the US, the 2.9% for the UK, and the 3.6% for Sweden; but that modest number would be significantly higher than last year’s 0.4% decline. As a group, Eurozone equity markets are up 3.46% year-to-date, as measured by the Morgan Stanley Composite Index (MSCI) (as of May 12). That figure compares favorably with 2.54% gain for the US total market and the -8.98% loss for Japan. Within the eurozone, Italy is up 14.03%; Spain is up 8.01%, with even greater outperformance by some of the small markets; Denmark +14.26%; and Ireland, +10.68%. Even France, which is experiencing some political difficulties, is up 4.67%. In contrast, the German market has been essentially flat this year. The negative readings of the latest German ZEW business survey help explain this surprising result for the economic powerhouse of Europe. The expectations component, which looks to the future, fell to its lowest level since January 2013. The German economy is slowing this quarter, and businesses are not seeing improvement down the road.

Our portfolios are at close to benchmark market weight for Europe, including country-specific positions in Germany, Spain, and Italy, along with the non-eurozone markets of the United Kingdom, Sweden, and Poland.

BY Bill Witherell