Despite the ECB’s policy action yesterday, which pushed out the date of the first interest rate increase and confirmed a substantial package of targeted bank financing intended to ease credit conditions for the corporate sector, the market reaction was largely negative. Yet a key part of our bullish call in January was that equity valuations had retreated to levels which were close to long-term averages, a relatively unusual occurrence in this economic cycle. Since then, equity valuations have rebounded sharply as markets have risen while 2019 consensus profits estimates have fallen. This was largely in anticipation of easier monetary policy in our view. We now expect markets to trade only sideways in the absence of a near-term catalyst, while awaiting evidence of a turn in the economy during Q2/Q3. In respect of a US/China trade deal, the apparent cancellation of the Xi/Trump summit due in late March is however unhelpful for sentiment.
According to a number of economists, the ECB yesterday delivered a positive surprise if not shock and awe by pushing out the date of the first eurozone rate increase into 2020 and introducing a new round of targeted long term refinancing operations (TLTROs), designed to improve the flow of credit into the real economy. At the margin, the extension to the lift-off date for interest rates also extends the period for which the ECB will continue to maintain the quantity of its corporate and government bond portfolio.
A prerequisite to this ECB action, in order to achieve a consensus at the ECB’s Governing Council, was a meaningful reduction in the ECB’s economic forecasts. According to press reports ECB internal sources believe there may even be more cuts to growth forecasts in future. ECB President Draghi has also confirmed that the risks remain tilted to the downside, even after the new policy direction. Forward market inflation expectations have also been falling to levels well below the ECB’s target of below but close to 2% inflation.
The reasons for the economic forecast downgrades were unchanged from the factors highlighted in prior ECB meetings; a slowdown in world trade, emerging market risks and a potential slowdown in the US as fiscal stimulus wanes, in addition to pervasive uncertainty due to the US/China trade conflict.
While the market may have been spooked by the extent of these downgrades to eurozone growth, on balance we believe investors should prefer a situation where the central bank perceives there is freedom to act decisively and on a timely basis. For example, during Draghi’s press conference a revival of QE was not ruled out, even if he was unwilling to speculate on any reintroduction at this time. We believe markets may be underestimating the political dimension within the ECB; press reports have also indicated that Draghi pushed hard for bold policy action at this week’s meeting, overriding more conservative policymakers. In any case, the alternative theory that the ECB is somehow aware of negative developments ahead of the market, based on past experience seems improbable in our view.
We also believe at this point markets are anticipating a resolution of the US/China trade conflict. However, the politics of the US/China trade negotiations ebb and flow. While additional US tariffs on Chinese goods were recently avoided and, according to China’s top diplomat Wang Yi, substantive progress has been made in trade negotiations the fluidity of the situation remains a concern. A planned late-March Presidential summit between Xi and Trump has been at least postponed following Trump’s failure to reach an agreement with North Korea. It would appear that China will require confirmation that the visit will be ceremonial, rather than a negotiation, to avoid the prospect of a similarly embarrassing outcome.
In respect of Brexit, time is running very short for any substantive change which would enable UK Attorney General Cox to change his advice that the backstop may be indefinite, given schedule for the Parliamentary vote next week. Cox’s reported proposals for independent arbitration and a mini-backstop provided the UK was shown to have acted reasonably appear ambitious at this stage. However, the alternatives for the UK – PM May’s deal, delay then PM May’s deal, delay than referendum and no Brexit – all continue to more probable than no-deal in our view, given the lack of support for no-deal in Parliament.
We believe investors should be careful not to over-analyse the negative short-term market reaction to the ECB’s policy changes, given the swirl of geopolitical news and shifting market sentiment. This is a case of buy the rumour, sell the news from our perspective. For the short-term, the remarkably sharp improvement in investor sentiment, with global equity indices up over 15% in US dollar terms since the low of 24 December, leaves market valuations at levels which are unlikely to entice value buyers. In theory, we would agree that the substantial easing in the outlook for developed market monetary policy over the last 3 months should support growth over coming quarters. However, there is clearly still some time to wait for the proof in the hard economic data.