Central Banks, Europe, and Oil
Posted on 26 January 2015
"As impressive and well-intentioned as the ECB's exertions are, they are unlikely to solve the key reasons for the bloc's economic sclerosis."
The actions of central banks are once again at the forefront of investor thinking – whether it was the Swiss National Bank’s abandonment of its franc/euro peg, the Bank of Canada’s surprise interest rate change on Wednesday, continued mooting of when and how the Federal Reserve will raise interest rates, or the much-anticipated European Central Bank (“ECB”) announcement of its expanded quantitative easing (“QE”) program. All eyes are on the world’s monetary mandarins. The ECB’s program is the latest iteration of its quantitative easing efforts. It consists of asset purchases of investment grade securities of euro area government and agency bonds. The initial response of the markets to the program has been positive, as European equity markets advanced 1.62% and US markets 1.53%.
This latest program is an effort to arrest the decline in prices within the euro zone that has been in effect over the last year. This expanded action by the central bank will be helpful but incomplete in solving the nature of the euro zone’s core problem. Indeed, we wrote in a prior US In Focus (see The ECB and the Laws of Physics, June 6, 2014) that the ECB should have engaged in the effort sooner than it did, since the transmission of QE into economic activity is not direct. In short, trying to change the direction of any large body, especially the roughly $17 trillion euro bloc economy, takes time. Increasingly, if we assess the investor zeitgeist with the euro project, it appears to be running out of time, as a recycling of well-worn concerns, such as Greece’s role in the euro zone, demands attention.
As impressive and well-intentioned as the ECB’s exertions are, they are unlikely to solve the key reasons for the bloc’s economic sclerosis. Labour market rigidity, lack of fiscal probity, and bureaucracy that hinders business creation are issues that monetary policy cannot fix – central bankers have admitted as much. The solution here is the tripartite solution we wrote about in the November 2014 edition of Compass.
However, what the ECB has done will likely continue to put pressure on the euro relative to its trading partners, which will help both the economies and companies in the bloc in lowering their cost structures and generate higher earnings through their international operations. Consider the earnings of large Japanese companies against a backdrop of a weak yen; they enjoyed a surge in profits (and their stock prices), as the cost of goods sold were cheaper relative to the revenues earned in markets with a stronger currency. For investors, this is one of the primary benefits that likely await euro zone stocks.
The ECB’s announcement is not the “silver bullet” that slays deflation. It is the necessary first step on the path to a more durable response to the problems facing the economic bloc. The next steps now fall to the governments in the euro zone to reform labour and business laws and regulations. In some cases, fiscal stimulus will have to be launched to gin up spending from an austerity-battered populace, and workers will have to agree to the reforms so an economic vibrancy can take hold. Wishful thinking, probably – critical, absolutely.
Something to consider: the periphery of the euro zone has been engaged in a grinding austerity for the last 7 years; its purpose has been to essentially lower the costs of doing business. Economists call it internal devaluation – everyone else calls it dreadful. This austerity has lowered costs in the periphery. Now with a cheaper currency, the economic bloc has effectively externally devalued, and by combining the impact of the external devaluation on operating costs, the bloc will become more competitive as Figure 4 reveals. Against this backdrop, conditions become ripe for the emergence of “green shoots of economic activity.”
From an investor’s perspective, the case for euro zone equities remains compelling: earnings are depressed, but costs of doing business have likely been reduced given years of austerity; and a cheaper currency is the catalyst for a lift in earnings – a view we have held for some time. Recent research from our Investment Bank colleagues bolsters our point from a technical perspective: sentiment toward European equities is negative, judging from negative investor flows into the market. Based on the performance of defensive sectors relative to cyclical sectors, investors don’t think QE will stimulate growth.
I’ve been travelling in Switzerland this week meeting with clients. My visit comes hard on the heels of the Swiss National Bank (“SNB”) decision to abandon its 1.20 franc/euro peg, which has been in effect since 2011. To say the SNB decision was unexpected is an understatement. Indeed, within 48 hours prior to the announcement, a member of the executive board had reiterated the bank’s commitment to the peg. While the reasons that motivated the decision abound, the fact remains that they made the decision, and now what remains to be seen is the effects.
Switzerland will see a drop in economic growth, as people shop in Germany and France, using a strong franc to purchase materially less expensive goods in euros, and as the cost structures of Swiss companies adjust to a significantly higher currency. A deflationary pull will emerge in the country, as companies cut prices to become more competitive. I have been told that a number of retailers and travel companies cut prices after the announcement. Indeed, I heard that Mercedes Benz cut prices of the cars it sells in Switzerland. These price declines will likely work their way into the inflation statistics. Watch for how the management of Swiss companies managed their cost structure while the peg was in place. Those who had the strategic foresight to plan for a stronger franc will be in much better shape than those who anchored themselves to the 1.20 franc/euro. The earnings season will be an interesting one, and it is one that will merit our attention.
I advanced the notion a couple of weeks ago that the strategy Saudi Arabia is taking as the swing producer in OPEC is to drive prices sharply lower long enough to destroy the willingness of energy companies to invest in new projects. The arc of the strategy runs something like this: prices below the average marginal cost of production take high-cost projects offline; projects approved but not started get put on hold; and capital budgets get slashed. This is happening. A recent BBC dispatch from Davos is a montage of reportage that makes the point; BP’s head said that the company is “planning for low oil prices for years to come,” and Eni CEO Claudio Descalzi noted the oil industry would cut capital expenditures by 10-13% in 2015. Furthermore BHP Billiton and Total were cited as planning to reduce their shale oil programs. This is how the willingness to invest is sapped.
Interestingly, OPEC Secretary General Abdullah al-Badri was quoted as saying: “We will go back to normal [returning to higher oil prices] very soon.”>
Yes, I am sure you will.
 Source: Bloomberg, as of January 22, 2015. European equity markets represented by Euro Stoxx 50 (local currency). US equity markets represented by S&P 500 Index. Past performance does not guarantee future results. An investment cannot be made directly in a market index.
 Barclays Research, European Equity Strategy: Three Questions on QE, as of January 21, 2015.
 Sadly, I could not score an invitation to the World Economic Forum. The content at this year’s gathering looks especially interesting.
 Source: Mercedes Benz Switzerland website, as of January 22, 2015.
 BBC News, 21 January, 2015: BP boss: Oil prices ‘low for three years.’
Hans Olsen, CFA Global Head of Investment Strategy