While the European Central Bank (ECB) has successfully eased financial market stress over the past two-plus years, Europe’s long-awaited recovery still remains fragile and imbalanced. The current uncertainties are focused around:
- Inflation (or the lack thereof).
- Future monetary policy actions.
- A still-encumbered eurozone credit-transmission mechanism.
- The growth-dampening potential of the Ukrainian conflict.
What the ECB is doing
There is growing concern that the ECB may disappoint on its primary mandate of managing inflation to “below but close to 2%,” – this concern is based on the fact that eurozone inflation has come in consistently below 1% since late 2013 and expectations for the coming year still remain well below 2%. This downward spiral of falling inflation expectations has continued to undermine both economic activity and, ultimately, investor sentiment.
In order to break the spiral it seems reasonable to expect that the ECB will need to do much more, by deploying some combination of additional conventional and unconventional measures in order to facilitate further convergence of lending rates across Europe, and foster greater economic growth and stability.
Encouragingly, the ECB cut its main lending rate in early June 2014 (from 0.25% to 0.15%) and, unexpectedly, also cut its deposit rate for banking sector excess reserves from zero to -0.1%.1 The second move (which made the ECB the first major central bank to introduce negative interest rates) is designed to further encourage banks to lend to businesses rather than hold onto the money.
In addition it announced a 400 billion euro targeted long-term refinancing operation (or “TLTRO”), which is effectively a four-year subsidy for banks to borrow cheaply at low interest rates (up to a max of 7% of their total loans to the non-financial private sector).2 This move is aimed at addressing a longstanding ECB objective, namely helping the eurozone’s small and mid-sized companies (a business sector long-starved of capital) to gain easier access to credit. Additional asset purchase programs are expected to follow — small at first, but with scope to rise considerably should growth and inflation disappoint further. The critical question at this point is whether ECB actions will be adequate.
Risks to success
The aforementioned moves by the ECB are positive, but more will be necessary. In the meantime, there are several risks to success, including:
- Any unanticipated shock to the economy that leads to a “risk-off” move by market participants.
- A global environment that remains disinflationary and actually gets worse, not better, leading to further monetary stimulus elsewhere. This could limit the ECB’s ability to orchestrate a weaker euro to stimulate growth and domestic inflation.
- A timing mismatch whereby banks continue to delever to satisfy asset quality review, stress test and leverage ratio objectives (thus limiting credit availability for the economy).
Potential beneficiaries
However, if the ECB proves to be successful the prize is clear:
- Banks stand to be the largest beneficiaries followed by peripheral European markets (southern and eastern Europe) and European equities in general.
- Short-term rates that are lower for a longer period of time, if coincident with higher inflation expectations in the coming years, would lead to a steeper yield curve, which would support bank lending margins and profits, as well as cyclical investment appetite.
- Stronger growth and an anchor to short-term interest rates would, other things being equal, also be supportive for sovereign yield spreads, particularly in Europe’s peripheral markets.
- Lastly, a weaker euro would ultimately serve to support growth that could feed the appetite for capital expenditure, a willingness to hire and a rebound (even if modest) in consumer spending (which would benefit cyclicals in the consumer and industrial sectors).
An extra eye on banks
Handicapping the near-term trajectory of the eurozone economy or the ECB’s next move is an exercise where few can claim a competitive advantage — ourselves included. Instead, our investment process and fundamental research continues to focus on the long term, devoting our energy to analyzing the potential risk and rewards should current trends persist or reverse.
Given the scenario laid out above, and the scope for improved regulatory visibility on the horizon, it should not be surprising that European bank stocks have started to warrant more of our research attention this year than they have for some time.
1 Source: ECB
2 Source: Financial Times, “ECB’s €400bn in cheap bank loans seen as ‘star of show,’” June 6, 2014
Important information
Risk-off is an investment setting in which price behavior responds to, and is driven by, changes in investor risk tolerance. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.
Delever refers to a company’s attempt to decrease its financial leverage. The best way for a company to delever is to immediately pay off any existing debt on its balance sheet.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity.
Yield spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. The higher the yield spread, the greater the difference between the yields offered by each instrument.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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