May 2, 2017    3 minute read

A Euro Momentum Switch: What’s in Store for the ECB?

A Turning Point    May 2, 2017    3 minute read

A Euro Momentum Switch: What’s in Store for the ECB?

The euro area has been getting considerably better of late. Whether it’s inflation data, unemployment figures or the softer sentiment indices, all numbers are trending upwards – so much so that it’s giving the European Central Bank (ECB) a bit of a headache: that is, attempting to devise an exit from this unconventional set up, without spooking the economy or markets

The European stock market has rocketed year on year. Unilever, Sanofi and LVMH, have all recorded double digit returns, while Unicredit has gifted 344%. The question is, will the stock market take a nosedive as QE ends and/or if rates are raised?

A Balancing Act

The euro area needs a particular strategy that allows banks, which are the core-funding channel, to restore to health whilst at the same time, maintain low borrowing costs for governments. The long-term refinancing operation (LTRO) a few years ago worked very well from a liquidity standpoint. It gave banks money in return for agreeing to use sovereign debt as collateral. This improved their capital position and gave them short-term funds to meet obligations.

However, this time around, Europe’s banks are in better shape – excluding Italy’s, to name one exception – so the ECB can afford to be more hawkish. They could increase the deposit rate (which currently sits at -0.4%), which would be beneficial for banks by increasing basic profitability while at the same time slowly tapering the bond purchases at the long end.

The next step would be to just maintain the stock of outstanding bonds. Raising rates would give confidence while banks’ new profitability streams could be used to lend out new capital. Money supply figures have been increasing on a month-on-month basis, as has loan growth. European data has definitely turned a corner, which gives the green light to the ECB to withdraw accommodation.

Repositioning Europe

If all this were to play out, what would be a good investment strategy? If the ECB were to raise rates then those sectors such as banks and insurance companies should benefit. Those who are heavily export-oriented should decline as the Euro strengthens, while domestic/cyclical firms should do well.

A bullish strategy for investors at this stage would be to go long on Europe and/or short the US. At an index level the two are heavily correlated so in order to benefit from European growth, buying individual companies would be more advantageous. US loans to the private sector peaked in Nov 2016 and each month since has seen this decline.

This contracting loan book means consumers will find it difficult to access credit, which in turn has implications for consumer durables and the housing market. Building permits have been choppy of late, while mortgage applications are trending south. All of this is interesting, particularly as the market expects the Fed to raise interest rates twice this year. If they do, they risk a recession. If they don’t, they risk losing credibility.

As a European investor, one could go long on European banks and short US homebuilders or banks. This is relatively risky given the European banking sector has underperformed the MSCI Europe since the crisis and the relative price- earnings multiples are higher in the US (mainly off the back of renewed fiscal hopes). However, the old saying, ‘be greedy when others are fearful’ might be the case here. Hedging out the currency would be an important element given the relative direction of central bank policy. Of course, more research is needed, but this could be a potential momentum switch to monitor.

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