Tuesday, November 25th, 2014

Free Riders & Thankless Children

ECB stimulus will leak outside the Eurozone

Another month, another whatever-it-takes speech from Mr Draghi: connoisseurs of Shakespeare may be reminded of King Lear addressing his fool, “I will do such things, what they are, yet I know not; but they shall be the terrors of the earth.” Like most Shakespearean tragedies, the play ends with all the main characters dead, but not before the king has been driven mad by the broken promises of his children. It is tempting to compare the ingratitude of various European governments with that of Lear’s daughters, but the real message lies in the madness of the king, making the same mistake again and again and expecting a different result.

It is of course necessary that the ECB provides enough liquidity to allow the banking system to function, but nobody, least of all the governments with the biggest deficits, believes that this liquidity is any longer conditional on the delivery of structural reform. In the absence of this conditionality the citizens of France and Italy, amongst others, enjoy a free ride from the ongoing fiscal strength of other countries. No matter, starting in December, the ECB will buy an ever wider range of securities, which will eventually include bonds issued by its member governments. Asset prices will respond; the underlying economies probably won’t. If they do it will be because of the depreciation of the euro, not because of an explosion of bank lending to the corporate sector.

Herein lies Mr Draghi’s basic problem: any action which boosts the attractions of Italian bonds, currently yielding 2.17% for the 10-year, will give a greater boost to US Treasuries, yielding 2.31% for the same tenor. The situation is even clearer when we compare bonds of similar credit quality. Germany yields 0.77% on the 10-year, or 0.12% on the 5-year, compared with 1.61% for 5-year US Treasuries. For an unconstrained investor, the rational response to the ECB’s intervention is to buy US Treasuries, achieving a significant improvement in credit quality or a material pick-up in yield and benefitting from the appreciation of the dollar. The ECB is offering investors an almost risk-free ride on the bonds of another country. Fortunately for Mr Draghi, many institutional investors in Eurozone have significant constraints on their ability to invest in overseas bonds. However, the ones we speak to are all asking for these to be relaxed. In other words, they expect much of the stimulus to leak outside the Eurozone.

There may also be a free ride in European equities – outside the Eurozone. Our country model shows that the equity markets of Germany, France and Italy, which have been near the bottom of our global rankings, are poised to start climbing. As yet, there has been no improvement in the probability of a superior risk-adjusted return relative to the rest of the world, but this ratio stopped getting worse in early November. However, the same model also shows that non-Eurozone equity markets, specifically Sweden and Switzerland, are higher up the ranking and started improving about a month ago. We expect the ECB’s intervention to benefit non-European bonds and non-Eurozone equities. They share much of the upside, but do not have the same downside risks.

Perhaps Mr Draghi should ponder one of King Lear’s most famous lines, “How sharper than a serpent’s tooth it is to have a thankless child.”

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