ECB may have left it too late

QE has occurred a bit late in the cycle, which makes its likelihood of success less clear-cut, writes Cesar Perez.

The European and the Greek flags fly above the ancient temple of Parthenon atop the Acropolis hill in Athens. AFP

Earlier this month the European Central Bank (ECB) started its long-awaited quantitative easing programme (QE). We believe the magnitude is significant as it will take the size of the ECB balance sheet back to €3.5 trillion by September 2016.

However, this major policy step has occurred a bit late in the cycle, which makes its likelihood of success less clear-cut. Deflationary pressures are already in place, as can be seen in the service sector inflation spiralling down. The spreads in the periphery are already at very low levels and small and medium enterprises’ funding costs have already improved, therefore the main transmission mechanisms will be through the currency depreciation and an improved securitisation market.

On the positive side, the open-ended nature of the programme flags the commitment of the ECB to its easing policy.

The purchase programme started at a time when economic indicators had already bottomed out.

Moreover, Europe is benefiting from a series of tailwinds for this year: improving consumer confidence, declining bond yields, currency depreciation, less fiscal drag and the drop in energy prices.

The size of the ECB bond purchases relative to the euro-zone equity market cap will be similar to programmes conducted elsewhere. Based on previous experiences in the United States and Japan, we believe that to be effective, QE has to be 20 to 25 per cent of equity market cap; therefore, at around 21 per cent of market cap, the ECB is aiming to be successful. A significant difference with other programmes is the sovereign bond supply dynamics, which will have a bigger impact on yields and the currency. At the time of the first US QE, the deficit in the US was close to 10 per cent. That number was around 8 per cent in Japan, while in Europe it is currently below 3 per cent.

In Europe, equity markets have performed well as the currency has started to devalue. Similar to the first phase in Japan, we are experiencing so far a “currency trade”, with multiples expanding to long-term average levels. For markets to continue to do well, investors need earnings to recover in the region as operational leverage kicks in while the economic momentum accelerates. The QE impact on European equity markets will be highly selective, depending on the exposure to a weaker currency and export potential.

The situation in Greece is less worrying than at the beginning of the year, however the situation has not yet been solved. Even following the reform plan accepted by the Eurogroup, the ECB and the IMF, Greece will still not receive funding until a final plan is submitted and approved next month. This means there may be a cash shortfall, including upcoming refinancing needs and potential lower tax revenues. Greece needs ECB support to bridge this gap. Eventually, more flexibility may be needed – not just by changing budget targets, but also potentially by introducing a different form of debt instruments. If Greece does not fulfil the European requests, ECB support might be constrained. While negotiations take place, capital controls are still not excluded, as happened in Cyprus.

Our conclusion on Europe is that ECB actions are welcome, although they might be coming a bit late as deflationary forces are in place, but size, commitment and timing, along with improving macro fundamentals, are all supportive.

Reforms still need to happen for this to be a structural change rather than just a cyclical one. Greece remains a significant political risk. We are on the lookout for the pockets of the market which benefit from a weaker currency and are not overly exposed to what remains a weak domestic consumption picture. Investors will need growth which translates into earnings through operational leverage for valuation multiples to hold.

Cesar Perez is the global head of investment strategy at JP Morgan Private Bank