One of the key events of this month in the financial space, the ECB meeting, concluded on a positive note for markets as the President of the institution, Draghi, met expectations as he openly acknowledged the possibility of additional easing measures. Hence, the policymakers reckon that the Euroarea economy is still facing sizable growth headwinds in the longer term notwithstanding signs that recovery is taking place. For investors this means that growth risks should become less worrisome and that more liquidity could become available.
Accordingly, in the aftermath of the meeting we have seen a strong rebound in equities and a fall in government yields (i.e. an increase in prices) as speculations continue to mount that additional measures could be announced as soon as December. In Draghi’s own words “the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”
Although a number of analysts have already voiced such expectations before the meeting, there were others who argued that additional action will only be announced Q1 2016; given the volatility of the markets over the last few months and the apparent fragility of investor sentiment, such a delay would risk hampering the efficiency of the programme particularly if Fed proceeds to increase rates in the meantime and/or the emerging market growth worries fail to subside.
Indeed, the latter were repeatedly highlighted yesterday as a downside risk and the ECB president hinted that the transmission channels are not limited to trade only “Increased uncertainty has recently manifested itself in financial market developments, which may have negative repercussions for euro area domestic demand.” Following a separate question on this topic, he further detailed that “On the direct trade channel, the conclusion is the exposure of the euro area to the Chinese economy is not very significant.
After all, the exports of the euro area to China are 6% of the total. However, there are some countries where such a figure is higher and reaches almost 10%, in the case of Germany. Still, I'd say this is not exceptional.
The second is so-called indirect channels, where you have also to account for the changes in oil prices and commodity prices that a higher recession in China would imply. The third channel is the financial channel and again we do not see a very significant exposure of the euro area towards China. But then there is another channel, which is the confidence channel.”
What is more, in his speech, Draghi pointed out that the appreciation of the EUR puts the bank’s inflation projection at risk. As such, emerging market developments are important from this perspective as emerging markets contribute more to the region’s trade than the US. To illustrate this, we look at the weights assigned to each country in the calculation of the trade weighted euro effective exchange rate. Excluding CEE countries, which have a share of around 10%, emerging market currencies account for over 35% of the measure; meanwhile US has a weighting of 13%. This means that a significant depreciation of the currency in emerging countries can be a noteworthy drag for Euroarea trade and inflation even if the EURUSD rate does not appreciate much.
To put it differently, the persistent monetary policy gap between US and Euro should support the depreciation of the EUR versus USD but the move might not be enough to offset the damaging effect of the emerging currencies depreciation. What is more, it is increasingly obvious that the latter are
prone to weakness should Fed move ahead and tighten its policy. Indeed, the Fed’s meeting next week is eagerly awaited by investors who apparently are largely dismissing the possibility of a move this year despite the bank’s guidance.
To conclude, I think there are compelling arguments for additional ECB stimulus later this year which bodes well for European assets, including equities, government bonds and corporate bonds.
This article was issued by Raluca Filip, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.