Recap 2015-03-05: On the ECB, and EU Equities

Commentary:

Of the forecasts, the 2017 inflation forecast is probably most pertinent, as it both fulfills the definition of ‘medium term’ and also is free of immediate QE and oil effects. That was likely a driver for initial sell off in EU fixed income. However, per the incomparable Frederik Ducrozet ‏@fwred, the forecast is a result of the fact that the ECB staff assumed the full impact of QE. That of course, is subject to considerable uncertainties, and Draghi noted that the farther out the forecast, the more uncertainty there is.

Draghi also noted that yields must be above the deposit rate of -20bps at the time of purchase. That resulted in a sharp bullish reversal in price action, as curve flattened, since it means that the Bundesbank will have to buy higher duration paper than the other central banks. Per Citi, It also means that the Buba will have to buy very close to the 25% issue limit in all remaining paper, assuming no change in market value. Again per @fwred, a response to fears that QE is constrained is that the *ECB SEES FLEXIBILITY ON CAPITAL KEY FOR MONTHLY PURCHASES and "There will be some flexibility for the NCBs to choose between purchases of CG securities and securities of certain agencies."

The price action following the meeting was obviously very bullish prices, and suggests that the 15 month rally is not over yet. I’d thought that the rich valuations, macro backdrop, move in US yields and move in equities would be sufficient for a retracement, but it seems to be too early for that view, or in other words, wrong. There may be additional clarity on this as the official purchases actually occur, given that the operational details remain only roughly defined.

Regardless, I think the fundamental analysis remains pertinent, even as the price action remains strong. Take a look at this 20 year chart of the US vs German 30y yield differential:

That segues well into a discussion on EU equities. I’ve noted recently that there is still upside. (Not that that’s an original view or anything) But the fact is that I haven’t been as bullish EUR equities over the past few months as consensus, and indeed my own models have suggested. The main reason is simply that by far the major reason for the EU outperformance YTD has been the ECB’s QE program; specifically, the effect on long dated sovereign yields. The surprise announcement that purchases would extend out to the 30y maturity drove a massive flattening across markets, leading to essentially a sharp drop in the financial discount rate for EU equities. As a result, despite earnings expectations that continue to fall, the present value of the expected earnings stream, the price, jumped. Arguably, essentially entire outperformance YTD has been driven by that.

So what’s the problem? Well, there is obviously a limit to how far that effect will go. And I think the limit is a lot higher than zero. In fact, in the case of Japan, the ability of lower long dated sovereign yields to drive higher equity prices fell very sharply once they declined below the 3% to 2% region. 30y JGB yields broke below 2% for the first time in late 1997. That seem to have roughly marked the period whereby Japanese equities cheapened, from a PE of around ~100x for most of the 90’s to ~17x today despite the fact that JGB yields are lower. In other words, that seems to have been when the market began using different metrics to value equities vs bonds in Japan.

That makes sense. After all, the closer the yields fall to zero, the more the bond (and any other financial asset) began to behave like a zero coupon bond. In other words, as interest rates fall closer to zero, more and more of the valuation becomes driven by the expectation of repayment of principal. For equities, the answer to that is obviously never; in other words, that valuation method breaks. In the case of Japan, the market seems to have basically began valuing the equity market on a comparison basis vs the US sometime around the turn of the century: (incidentally, that was the last time the 30y JGB touched the 3 handle)

This is all especially pertinent for EU equities because the GDP weighted 30y sovereign yield for the Eurozone is now something like 1.55%. In other words, it is clearly below the 2-3% area that marked a valuation paradigm shift for Japanese equities. In fact, it is just barely above the current 30y JGB yield.

The net result of all this is simply that it is likely that the ability for the ECB to further drive EU equity prices via lower yields is likely near an end. Obviously it can use more unorthodox measures like the BoJ has done – ‘irresponsible’ size QE, outright purchases of equities, etc – but those methods all have their own drawbacks, and in particular for the ECB, would require a level of political consensus that will be difficult to achieve. Additional EU equity performance going forward is likely to be almost exclusively driven by actual earnings growth. For an economic entity as challenged as the Eurozone has been, that is a tall order.

And that’s not all! The combination of the current low level of interest rates, in conjunction with a hawkish ECB mandate, (inflation driven only, rather than growth) suggests that the chances of high real yields are bigger in the Eurozone than in other areas. With respect to a long term time horizon, that is something that is likely to pose a significant pricing risk.

Anyway, that’s all a longer term view of things, quite different from the shorter term outlook. Astute readers will note that the US is not that far away from this situation and I would agree. But with a 120bp spread between the 30y points, there is probably still a sufficient cushion before we get there.

Notable:

  • ECB: will start purchases on March 9th, will purchase debt down to the -20bp deposit rate. The risks surrounding the economic outlook for the euro area remain on the downside but have diminished following recent monetary policy decisions and the fall in oil prices. Draghi was dismissive of concerns of a lack of bonds to buy.
  • ECB Growth Forecasts vs Previous:
  • 2015 1.5% vs 1.0%
  • 2016 1.9% vs 1.5%
  • 2017 2.1% vs 1.65%
  • ECB Inflation forecasts vs Previous
  • 2015 0.0% vs 0.7% due to oil
  • 2016 1.5% vs 1.3% due to QE
  • 2017 1.8% vs 1.55%
  • Additional details on the implementation: https://www.ecb.europa.eu/mopo/liq/html/pspp.en.html
  • If the purchasable volume of marketable debt instruments issued by the central government and agencies is insufficient in the respective jurisdiction to accommodate the corresponding share of purchases under the ECB’s capital key, substitute purchases are foreseen. If these substitute purchases comprise marketable debt instruments issued by international or supranational institutions located in the euro area, such purchases will be subsumed under the 12% allocation for these securities in the PSPP. The remaining purchases of marketable debt instruments issued by international or supranational institutions located in the euro area will be conducted on behalf of the Eurosystem by the Banco de España and the Banque de France.
  • Also here: https://www.ecb.europa.eu/mopo/liq/html/pspp-qa.en.html
  • BoE kept policy unchanged as exp
  • Brazil increased rates by 50bps to 12.75%, as expected. The decision was unanimous. This was the third consecutive 50bp rate hike following the initial October 29 +25bp hike. The continuation of the rate hiking cycle at a 50bp pace despite a weak economy reflects the very challenging inflation outlook and the impact on projected inflation from a weaker BRL (in the January 21 meeting the Copom was working under the assumption of a BRL/USD flat at 2.65 over the next two years, but the currency is now trading a striking distance from 3.00).
  • UPS says the weaker euro is causing European exports to the US to spike. EU-to-US exports are up greater than 10% y/y, "an unexpectedly large and fast change in global trade flows."
  • China’s Premier set 2015 GDP growth “around 7%” down from 7.5% in 2014. 2015 CPI around 3% down from the 3.5% target in 2014. Both of these had been well telegraphed.

Upcoming:

  • Fri: EU 4Q GDP, US Employment
  • Mon: ChinaTrade, Japan Eco Watchers Survey, Australia Business Confidence, China CPI,
  • Tue: Japan Machine Tool Orders, US NFIB Survey, USDA Ag report, AU Home Loans
  • Wed: ChinaData, US Oil Data, RBNZ, UK RICS House Prices Balance, AU Employment
  • Thu:
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