THE EUROPEAN Central Bank (ECB) has finally started to implement its quantitative easing (QE) programme, which consists of a stimulus package worth one trillion Euros, and will purchase government bonds throughout the Eurozone. Citi Research Group’s Panic/Euphoria model shows how investor confidence is far more euphoric than the pre-crisis levels in 2007, currently standing at 0.66 on the chart. Is this euphoria justified? Many investors feel that QE will offset many concerns surrounding deflation and stagnating growth, but despite investor confidence I feel that bucking the trend and betting against European markets is a far more appealing investment prospect.
The first major concern that I have is that this programme will create a huge amount of excess liquidity within the financial sector. The European Banking Authority (EBA) recently published the results of its stress tests which aren’t too promising. Out of 123 banks assessed, 10% failed the test in October of last year with a further 24% only just meeting the required capital positions on their balance sheets. The problem facing these financial institutions is that they and their governments face a dangerous balancing act. The ECB intends to extend extremely cheap credit to the governments of the Eurozone who then buy up the non-performing loans of these zombie banks. Judging by the recent EBA tests, many of these banks seem to be close to reverting to zombie banks. Many banks across Europe are drastically shrinking their balance sheets and size of their operations. This presents a problem as the QE programme intends to increase bank liquidity and encourage banks to increase their capital, adhere to ECB capital ratios and at the same time increase the provision of credit to companies to stimulate the economy. If these banks aren’t in the position to lend whilst maintaining their capital ratios, the cash created by QE is just deadwood and will have saddled the State of its respective country with massive debts from their providing liquidity to those banks finding their capital and reserves shrinking in an effort to write down their non-performing loans and manage their shrinking of their balance sheets. In an environment where many banks also found difficulty in finding suitable credits there has been a tendency to find alternative investments/assets for banks to invest and provide a suitable return. This has resulted in a familiar situation where “bubbles” are being created again. This is particularly the case in property and stock markets.
Many feel that QE is nothing more than another credit easing measure. The result of QE could emulate the events of the 2003-2007 recovery. During this recovery, rising interest rates around the globe massively eroded and corrected the values of overinflated stock market values, ultimately revealing the credit driven bubble as the main driver of this increase. Presently the UK and Eurozone are driven by rapid increases in the growth of the credit markets due to low interest which for the UK stands at 0.5 per cent which have been heavily bolstered by the FIAT money created by the Bank of Japan and Federal Open Market Committee. This has caused markets around the world and the FTSE 100 to soar to a record high of 6919 on the 1st of March 2015, triple the FTSE100 in 1990 which stood at 2422. However this growth is based directly and indirectly upon the performance of corporations within the dominant financial sector.
Initially QE programmes tend to be beneficial; however the programme has to be directed by the government into stimulating the real economy instead of propping up the unseen economy. If we take the UK into account, it has faced massive productivity issues as there has been far less investment directed towards infrastructural projects and the revival of our manufacturing sector. This has not helped in reducing the huge trade deficit resulting in an increased deficit in the country’s balance of payments. The situation the UK faces is in some respects similar to most Eurozone countries with the difference that not being in the Eurozone allows for interest rates and monetary policy to be pursued in support of the Pound and economy. The country which most Eurozone members should emulate is Germany. Germany is a country which has a balanced economy, which is driven by its large export surpluses and stable currency. The fear is that QE was will result in result in interest rate fluctuations over a number of years in the future. The uncertainty arising from countries attempting to counteract inflation will undermine one of the greatest requirements of investors; stability and predictability of macroeconomic factors.
Central Banks around Europe have seen considerable swings in investor sentiment as interst rates have declined due to actions of ECB, where rate management reflects the interests of the stronger Eurozone country’s at the expense of the weaker. QE will only add to this sentiment and mainly as the consequence of the rapid increase in liquidity arising from QE. Sales of Government debt are significantly affected by QE as the rates and increased liquidity have a marked effect on sales of debt and often reflect short term reactions to Government policy and are not conducive to a stable predictable market, which is a perquisite of a settled stable debt market.
The consequences of the QE programme have a global impact and the effects of the bubble extend to emerging markets. The recent announcement signalling the end of QE by the Federal Reserve Bank (Fed) caused significant panic and in emerging markets, where currencies and stock markets fell with resultant increases in interest rates to manage the decline. The excess cash created from QE, started to return to the US in the anticipation of higher interest rates and the recognition that the economy appeared to have achieved a position of sustained economic recovery. Unfortunately, the increasing cases of competitive devaluation will not be helped by this move by the Fed as increased rates and the return of short term investment to the US could become a flood and have a severe medium term impact on emerging economies. Although emerging economies have learned from their errors in borrowing US$ in the 1990s, when they were attracted by low rates, this will not happen to the same degree on this occasion but the effect on their economies could end up being as severe as many of their companies have fallen for the attractions of low rates and not appreciated FX risk.