Is the ECB helping or hindering?

Paul Wilson, portfolio manager and head of asset manager research at Sanlam.

At the 68th annual CFA Conference this year, Dr Jurgen Stark, an ex-member of the European Central Bank (ECB) executive board, spoke out against the Quantitative Easing (QE) programme recently embarked on by the ECB. ‘A risky experiment,’ he labelled it. These are his reasons.

1 Capital is misallocated

One need only look at some negative government bond yields (e.g. Germany and Switzerland) to know that this is not a sustainable or normal environment, and that those investors who are locking in negative yields are probably misallocating their capital. However, it’s not just in financial markets where this is happening. Companies and banks, especially the so-called ‘too big to fail’ ones, now have less incentive to properly adjust their balance sheets with effective ‘guarantees’ in place on them if they are unable to pay their debt.

2 It will be less effective than in the US

In the US, QE had a positive effect on the wealth of individuals, particularly as low interest rates and monetary stimulus boosted global, and in particular US, equity markets. The increase in wealth meant that Americans felt they could spend more, which assisted economic growth. In Europe however, Dr Stark contends that most Europeans are far less exposed to equity than US citizens. Data on German pension funds, for example, show that the average exposure to equity has been less than 10% over time while bond exposure has been over 75%.

3 QE will not address the imbalances within Europe

One of the outcomes of the European QE program would be a weakening of the euro, which we’ve already seen to some extent. While this makes Europe more competitive, countries like Germany stand to benefit most and not countries such as Italy and France, who need the assistance more. This is the same problem which has been plaguing Greece since 2008. The currency is normally the ‘release valve’ for a pressure build up, however the depreciation is insufficient to assist Greece, Italy and France meaningfully. As a result the imbalance within Europe is likely to grow even greater.

4 The world has become reliant on central banks

Since the US first began its QE programme, central banks have found their status elevated to that of powerful political tools. This has been echoed by the likes of Gill Marcus, SA’s Reserve Bank Governor after the Global Financial Crisis, who repeated many times that permanent economic growth cannot come from central banks only, but also needs to come from reforms. However, financial markets continue to be lifted by ongoing interventions by central banks, which have never been as accommodative on a global scale as in the past seven years. In some cases the balance sheets of certain central banks have more than doubled as a percentage of GDP. For example, Japan’s central bank balance sheet is close to 70% of GDP. This means financial markets have become overly sensitive to announcements by central banks (e.g. the taper tantrum).

Dr Stark has a different solution

Dr Stark contends that the only way to sustainable economic growth is through reforms that increase productivity. The QE programme has bought governments time to get these reforms right. However, due to political will and complicated international relations in Europe the reforms are not being implemented fully. Governments have not used this ‘borrowed time’ wisely. As a result Dr Stark feels that interest rates will need to be low in Europe for some time and he expects the first interest rate increase in 2019 only.

We believe the ECB’s actions were not in vain

While Dr Stark raises many valid concerns, we’re not as negative as he is on QE in Europe. The ECB had to do something to assist the economy to grow. The effect has been immediate in the weakening of the euro, which has already benefitted Europe, with some positive growth signs coming through. The imbalances will perpetuate if reforms are not implemented, but at least the ECB has deflected a deflationary environment with no growth, which could have led to a break-up as poorer countries battle with higher unemployment and social pressures.

Global asset prices have soared, though

Asset prices in many instances are certainly high. This is not just as a result of the massive global monetary stimulus over the last few years, but also of the extremely low interest rate environment recently. These higher asset prices do present risk and volatility, and prudence is warranted.

The effect of all these monetary stimuli is likely lower returns going forward, as interest rates begin to normalise. There will be market corrections, which may present opportunities, but we’re not expecting a doomsday event akin to the 2008 Global Financial Crisis. What we’ve learned is to what lengths central banks will go to prevent a repeat of 2008. Government certainly needs to come to the party in many regions, particularly in Europe and many emerging markets, such as SA, to avoid a prolonged period of low returns. Therefore diversify your portfolio, look to alternatives (which we believe will play a bigger role going forward) and be prudent when allocating capital going forward.