Draghi Disappoints – what next?
On October 22, Mario Draghi, the president of the European Central Bank, advised markets that he was prepared to cut interest rates and step up quantitative easing to stave off the risk of a renewed economic slump in the eurozone.
However, last Thursday, he failed to deliver stunning the markets as the announcement fell short of market expectations. In this article I will try to tackle investors’ concerns as we head towards the close of 2015 and the start of a new year.
What were market expectations?
In the run up to the ECB meeting, investors went into risk-on-mode as markets kept on rallying with the hope that the ECB would increase its bond buying programme from €60 billion per month to €70 billion. Even more so, there were analysts who were expecting an increase of €20 billion to the bond buying programme. As a consequence, the German DAX rallied circa 15 per cent from its lows in September as investors leveraged their positions in expectation of further quantitative easing.
The increase in market prices resulted in equities trading above fair value. However, this was acceptable because an increase in quantitative easing would have justified an improvement in forward P/E ratios and in turn an improvement in price targets.
The fact that this didn’t happen resulted in a correction in equity markets, pushing equity prices back down to fair value.
What happened last Thursday?
On the day, Draghi spoke about everything apart from increasing the bond buying program. This is because there are no signs of a renewed economic slump in the eurozone.
The fact that we are seeing an improvement in economic data from the Eurozone reduced the need for further quantitative easing. From European PMIs to lower unemployment rates to higher inflation, all these positive data reduced the urgency for the ECB to contribute further to the markets.
Nonetheless, this resulted in a sell-off in equity markets with the DAX down 3.6 per cent (for the day). No additional quantitative easing also resulted in a strengthening of the EURUSD with the Euro up three per cent (on the day). It is important to understand the strong negative correlation between the European equity market and the value of the Euro.
Where are markets going from here?
In my opinion the one day correction on Thursday was overdone. However, rest assured that volatility is here to stay. We are soon going to close off the year and European markets are up 10 per cent. Investment managers would want to protect their profits.
On December 16 we expect the Fed to start raising interest rates in the US. A rate hike is already priced in, so we do not expect a surprise here.
Although 2015 did not end with a bang for European equities, the German DAX still returned a respectable 10 per cent so far this year, compared to the 10-year bund which is only yielding 0.66 per cent.
Despite the negative turn of events, I expect European equities to continue to generate positive returns for shareholders in 2016 as economic data continues to strengthen, companies continue to report an improvement in results and the ECB remains supportive with its policies.
Disclaimer: This article was issued by Kristian Camenzuli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is 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. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.