David Roberts

Where is the emergency?

David Roberts

Yesterday’s European Central Bank (ECB) meeting and press conference continued the pattern seen since Mario Draghi was confirmed as President of the Bank back in 2011.

Striking a note of caution with respect to the economic outlook, Mr Draghi reminded us all that the ECB “has our back” and can provide greater market stimulus if needed. As a result, the euro weakened, bonds and equities rose: once more, investors were left scratching their heads as ten-year Bund yields threatened to move back below zero.

Undoubtedly, the European economy faces a few headwinds: populist unrest remains an issue, inflation has failed to move above target and growth has been lacklustre. However, we know the German economy suffered a number of idiosyncratic issues late last year and is likely to rebound in the first quarter. Unemployment is lower than it has been since the Berlin Wall came down and even in France, where the gilet jaune movement took its toll, manufacturing has just returned to positive territory.

Policy rates remain at emergency levels and that is really what I cannot fathom. Where, exactly, is the emergency? Take Italy for example: a year ago, we thought they would breach all sorts of eurozone treaties and bonds were in freefall; today, that situation appears much more under control and doesn’t scream “emergency”.

It is true that banks appear unable to fund and subsequently lend at economic levels without ECB support. For me though, that is more a structural than economic issue. Failure to properly clean the Euro banking system 10 years after the global financial crisis means balance sheets remain bloated, bad debt levels too high and capital allocation inefficient. But simply providing more cheap money to banks is not solving the problem: structural reform, system wide or institution by institution, has just been kicked down the road. Again.

Lastly, to inflation. Eurozone CPI (Consumer Price Index) has actually risen quite nicely over the past three years and while still slightly below target, talk of persistent deflation has proved unfounded. It is worth considering quantitative easing (QE) and its inflation impact here: simply put, QE depresses the cost of money finance is a major input to almost all business. Reduce an input cost and often output costs fall too.

Perhaps, just perhaps, cheap finance has contributed to low inflation. And of course, if we assume cheap finance has left more companies in business than would otherwise have been the case, then the law of supply and demand dictates the products these companies produced would have to be sold at a lower price than the normal clearing level.

QE and false borrowing costs in the short term may have saved the system. Implemented in the longer term there is mounting evidence they create inefficiency, could be deflationary and support bloated institutions that would struggle to survive in a free economy. How very European.

In terms of our portfolios, we are desperate to short the German bond market – to position ourselves to make money as and when the market falls. So far, despite Bunds being very expensive, we have avoided doing that and just have zero exposure. It is very difficult to swim against the tide, even when we know the tide is carrying us toward some pretty scary rocks.

In real terms, Bunds have been a poor investment for several years but they have produced small, positive nominal returns. Despite the low yield, investors have been playing a game where they buy Bunds and swap them into US assets.

Such is the extent of ECB manipulation that in the short term, investors can still make money doing this even though US bonds actually yield 2.5% more than German ones. Suffice it to say this is a dangerous game and the pitfalls are many. With hindsight, I would suggest this type of trading exacerbated market volatility in December. Given central banks are supposed to care about market integrity and stability, I would question whether encouraging cross border speculation is really what they should be doing.

And that of course makes me part of the problem – I am zero weighted to some of the world’s most expensive assets. However, a recognition and fear of the false technical demand makes it difficult for me to risk investor capital, for the next few months at least.

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Friday, January 25, 2019, 11:05 AM