Financial markets are experiencing heightened volatility these days, driven by concerns about slowing and uneven global economic growth. One of the most worrisome areas is Europe, which has long struggled with chronic low growth and technically crossed into deflationary territory with a negative inflation reading for December. As the next European Central Bank (ECB) policy setting meeting approaches on January 22, we think the odds are high that the central bank will be the last major entrant into the quantitative easing (QE) game. If this happens, will the bond buys have a meaningful impact in removing Europe from deflation, as was the case in Japan? Or has the ECB waited too long and missed the opportunity to free the eurozone from its near recessionary doldrums and lift inflation closer to the target?
What is the ultimate goal for the ECB? This impactful tool was not as accessible to the ECB as compared to other central banks. First, the legality of a QE program across the zone was in question until a recent court ruling cleared the final hurdle. Another shared reason is since the eurozone is a monetary union, not a fiscal union, the decision on which assets to buy and from which country is a politically fraught one.
Whatever next steps the ECB decides to take, the goal is to raise inflation from its very depressed levels and achieve price stability. ECB officials hope to weaken the euro, which should help to anchor actual and expected inflation. They will also test the theory of whether reducing yields across safe haven assets like government bonds incentivize banks to lend more. The jury is still out on this.
Will it work? The legacy of the European debt crisis has affected the psyche of consumers and businesses, stifling demand and diminishing economic output. Until we see more pro-growth stimulus and structural reforms (especially in the labor market), we think QE will serve more as an economic stabilizer than a solution for Europe’s chronically slow growth.
Where are the investment opportunities? Despite valuations that appear cheap relative to the United States, we remain neutral on European equities because of downbeat sentiment and little conviction that growth will accelerate. That said, a larger-than-expected QE program would be a tailwind for European cyclical companies as it would expand multiples, in much the same way that U.S. QE has driven valuations higher. In fixed income, we find short-dated Spanish and Italian debt relatively attractive, as we expect spreads to continue to compress against German bonds. European investment grade debt could also benefit from investors seeking more yield. Finally, we expect a weaker euro, even as we take into account that the euro/U.S. dollar exchange rate has already fallen from a one-year high of 1.39 in March 2014 to the current level of 1.18.