Can Super Mario Save The Markets (Again)?

Problems? ECB President Mario Draghi has problems:

  • The Eurozone economy grew 0% in the second quarter. In other words, it didn’t.
  • Germany, previously a bright spot, contracted 0.2%. Italy fell back into recession.
  • Some believe the sanctions war with Russia killed off Europe’s anaemic recovery.
  • Others blame France and Italy for dodging structural reforms.
  • Meanwhile Eurozone inflation has dropped to 0.3% — a hair’s breadth from deflation.

 There are now real fears Europe could suffer the same deflationary spiral that dogged Japan for decades.
For Mr Draghi, every day must feel like Monday.

The story so far

Of course, Draghi – aka ‘Super Mario’ to analysts who grew up playing Nintendo games – has not been standing idly by.

You may remember in summer 2012 he said he’d do “whatever it takes” to save the Euro as it threatened to unravel.

Back then the yields on European government bonds were diverging wildly, with investors dumping the debt of Italy and Spain to buy bonds in sounder Eurozone economies – particularly Germany.

The implication was clear: The market favoured stronger European economies because it saw a good chance that weaker countries – and their liabilities – would be ejected from the Eurozone.

Well, two years on and Draghi’s powerful words — and to a lesser extent actions – have dealt with all that.

The ‘spread’ between Italian and German 10-year government bonds is now around 1.5%.

This means investors are only demanding an extra 1.5% in interest for holding Italian debt.

In 2012 that premium hit 5%!

Deflated expectations

It is good news that Draghi convinced investors the 18 Eurozone countries are all in it together.

But the bad news is that this now seems to mean they’re all pulling each other towards the deflationary abyss, strong and weak alike.

Yet this risk of deflation could ultimately be good news for investors.

You see, unlike the US Federal Reserve, the ECB isn’t supposed to be directly concerned about economic growth or unemployment.

The ECB’s mandate is to ensure ‘price stability’.

So while Mr Draghi might not believe economic miserableness is in the best interests of the Eurozone, he needs the cover of inflation – or potential deflation – to act.

And with inflation falling towards the dreaded 0% mark, it seems to me the ECB President has the mandate to truly do whatever it takes.

QE, or not QE?

During 2014, Draghi has already:

  • Cut the benchmark interest rate to 0.05%.
  • Implemented a 0.2% ‘negative interest rate’, to penalise lenders for parking funds with the ECB overnight.
  • Offered European banks up to €400bn in loans at a cheap interest rate of just 0.15%.

His aim is to get money flowing in the Eurozone, by encouraging banks to lend and increasing the ECB’s balance sheet.

So far the results have been disappointing. Banks took up just €83bn of that €400bn of cheap cash last week, for example.

Next up the ECB will start to buy asset-backed securities. Again, it hopes that injecting cash will encourage banks to boost lending.

But these measures may not go far enough. The US Federal Reserve and the Bank of England bought government bonds in their QE programmes, which the ECB is not yet proposing to do.

Critics say only ‘true’ QE will jolt the Eurozone out of its torpor.

They predict the ECB will have to turn to full QE in 2015 after the current approach fails – over the protests of Germany, which fears that buying the bonds of weaker countries will take the pressure off their leaders to implement reforms.

Banks are bashful

There’s something else, too.

For my part I doubt European banks will start lending freely until the ECB’s Asset Quality Review (AQR) is concluded in the next few weeks.

The AQR is the ECB’s version of the Fed’s stress tests that helped get US banks back into shape.

If European banks are not sure which of their brethren are truly safe and how much damage the troubled ones are hiding, I’m not surprised they continue to horde cash.

Hopefully the AQR will give the stronger banks the confidence to lend more – presuming that the demand is out there.

Bring out the big bazooka

If the ECB does implement full-blown QE and money does start to move, then the results could be dramatic.

For starters, it’s possible that Draghi might just get what he wants.

If QE injects more money into the European economy, it could ward off deflation, increase lending and investment, shore up economic growth, and avoid a prolonged recession.

All that would be good news for any European companies you own, in trackers or funds if not directly.

And it would also be great for UK companies who do a lot of business on the continent, from Renishaw to Sage to Vodafone.

A boom made in Europe

Yet massive monetary easing by the ECB could go further to help support asset prices globally.

Think about it.

The initial aim of QE is to lower long-term Eurozone bond yields. These are very low already — the yield on the 10-year German bund is barely 1%.

Meanwhile, the US Fed is tapering its QE programme, and both the US and UK are expected to start raising interest rates in 2015.

See the disconnect?

The ECB could be making money more plentiful and lowering Eurozone yields even as the US and UK tightens.

Money that would have been invested in German, French, Italian or Spanish bonds might therefore go to the US and the UK in search of higher yields.

That would depress the yields on our government bonds, or at least stop them from rising as quickly while US and UK Central Bank rates rise.

And (still with me?) this would keep the so-called ‘risk-free’ rate here and in the US much lower – which would be good for share prices, because investors judge the attractiveness of equities partly by comparing their valuation to the safer returns from bonds.

Bottom line: this bull market may yet have further to run.

But we’ll have to watch what Super Mario does next…

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The Motley Fool has recommended shares in Renishaw. Owain owns shares in Vodafone.