Monday, November 23, 2015

Mario Draghi’s Worst Nightmare?

 David Oakley of the Financial Times reports, Nightmare of Mario Draghi’s crowded trade:
Investors are putting too much faith in Mario Draghi. The European Central Bank president is largely responsible for one of the most overcrowded trades in markets — and there is a risk it could all go horribly wrong.

In the past month, every investor I have spoken to has told me they are overweight European equities, citing the quantitative easing policy of Mr Draghi and the ECB as one of the main reasons. But is Mr Draghi creating a potential nightmare scenario for investors?

The European equity trade makes sense for a variety of reasons. The eurozone economy is recovering, albeit sluggishly, earnings are growing, valuations are relatively attractive and, most important of all, the ECB is buying billions of euros of bonds to underpin the market.

Indeed, European equities have rallied sharply since the start of September when Mr Draghi first hinted he was prepared to launch a second round of QE, expected in December.

Investors reason that it is unwise to fight a central bank. It makes sense to be fully invested in risk assets such as equities when a central bank is actively easing, as looser monetary policy encourages corporations to borrow at cheap rates.

This is certainly true. Euro-denominated investment grade corporate debt issuance has surged to a record high so far this year. This corporate borrowing often translates into higher profits as the money is invested for growth, which in turn boosts the share price.

With the US Federal Reserve expected to diverge from the ECB and tighten policy next month, it makes European stocks even more appealing, particularly given that US valuations are stretched.

With the ECB easing and the Fed tightening, the euro is likely to remain weak. A cheaper euro should lift demand for exports. This is helpful to Germany, the region’s biggest economy, which relies on exports for growth.

However, when a trade becomes this crowded, there are risks.

Upside is limited because the good news is largely priced in. More significantly, if the market reverses, it can be difficult to exit as everyone wants to sell at the same time.

Investors only have to look back to the summer for a reminder of the dangers. Worries about the Chinese economy wiped out all the equity gains from Mr Draghi’s first round of QE, which was launched in March, in a matter of days. European equities plunged about 10 per cent in August.

Yet some investors remain sanguine about China. They think the Chinese can keep the economy ticking over at a relatively healthy rate. The latest Chinese data show the economy is growing at just under 7 per cent.

Although there are some doubts over the accuracy of China’s figures and they are nowhere near the rates of close to 12 per cent before the financial crisis, a number of investors think growth is at least 6 per cent, enough to maintain global growth and underpin market sentiment.

According to the World Bank, the expansion of the Chinese economy in the past decade means it is contributing more to global gross domestic product at its current growth rate than it was in the pre-crisis boom years.

But these same investors made this case before the summer sell-off. If Chinese growth falters and the country depreciates its currency again, then Europe will suffer. Not only will it undermine the big German exporters, it could import deflation to Europe.

Some argue that Mr Draghi could simply keep expanding QE. The US spent three times more than the current ECB programme of €1.1tn in three rounds of QE over more than five years.

But did the ECB join the QE game too late? With Europe’s economy barely growing and inflation below target, Mr Draghi might not be able to save the region. Those investors stuck in an overcrowded trade will then have to pay the price.
I agree with David Oakley, with Mario Draghi hinting at increasing the ECB's quantitative easing in December, there's this euphoria going on in European shares which could end very badly if things don't turn out as expected there.

Go back to read my October 2014 comment on why the mighty greenback will surge higher where I wrote the following:
I've been warning my readers of the euro deflation crisis and having just visited the epicenter of this crisis, I came away convinced that the euro will fall further. In fact, I wouldn't be surprised if it goes to parity or even below parity over the next 12 months. There will be countertrend rallies in the euro but investors should short any strength.

What is my thinking? First and foremost, the European Central Bank (ECB) is falling way behind the deflation curve. Forgive the pun, but as long as Draghi keeps dragging the inevitable, meaning massive quantitative easing, the market will continue pounding the euro. The fall in the euro will help boost exports and more importantly, import prices, fighting the scourge of deflation.

Once the ECB starts ramping up its quantitative easing (QE), there will be a relief rally in the euro and you will see gold prices rebound solidly as inflation expectations perk up. This is counterintuitive because typically more QE means more printing which is bearish for a currency -- and longer term it will weigh on the euro -- however over the short-run, expect some relief rally.

But the problem is this. You can make a solid case that the ECB has fallen so far behind the deflation curve that no matter what it does, it will be too little too late to stave off the disastrous deflation headwinds threatening the euro zone and global economy.
And where are we a year later? With the exception of Greece, all of eurozone's economies are doing much better but this is more of a cyclical swing due to the decline in the euro. Nothing has fundamentally changed in the eurozone to address deep structural factors that all but ensure a protracted deflationary episode in that region.

In fact, Alessandro Speciale of Bloomberg reports, Europe's Contented Workers Could Be Worsening Draghi's Deflation Woe:
Low inflation, Mario Draghi once famously said, means people can “buy more stuff.”

The consumption-driven recovery in the euro area is currently proving the ECB president's point. But can the consumer be in too good a mood?

If price gains are so slow that employees stop seeing the need to demand higher wages, then that makes Draghi's task of returning euro-area inflation back to the target of just under two percent all the more difficult. Euro-area annual inflation came in at 0.1 percent in October.

Wage settlements in the region rose an annualized 1.56 percent in the third quarter, just above the record-low of 1.44 percent at the beginning of the year, ECB data released Tuesday show. While the bloc's unemployment rate of just under 11 percent is clearly weighing on salaries, even in areas where joblessness is low, like Germany, there are few signs of wage inflation.

“Workers adjust their demand to the low inflation pattern,” said Alexander Koch, an economist at Raiffeisen Schweiz in Zurich. “The current environment doesn’t push workers to request higher wages.”

To be sure, wage dynamics are notoriously asymmetric; especially in Europe they don’t contract in response to a downturn as much as they rise during a boom. And while they are near a record low, that's still way above inflation.

But soft wage settlements today can crystallize weak inflation for years to come. That's one of the reasons why the ECB will consider fresh stimulus at their Dec. 3 policy meeting.

“Salaries are probably the main driver of services inflation,” said Marco Valli, an economist at UniCredit SpA in Milan. “This low level of wages growth confirms a picture of only slow pick up in core inflation.”
All this to say the last thing the eurozone needs is another Big Bang out of China which will export more deflation to the region. In November 2014, in my comment going over deflation coming to America, I explicitly stated this:
[...] Europe is already spiraling into deflation, and if Chinese deflation gets worse and they are forced to devalue the yuan, it will flood their economies with cheap imports, exacerbating the euro deflation crisis at the worst possible time.
And let me share something else with you, a chart I saw on Friday as I attended a luncheon where Amundi's Global Head of Research, Philippe Ithurbide, went over his top down economic and financial overview. At one point, Philippe showed us the chart of the trade-weighted euro (click on image):

As you can see, the decline of the euro relative to the U.S. dollar has been steep but on a trade-weighted basis, it hasn't really declined because emerging market currencies and the Chinese yuan have declined a lot more. And that's where all the trade is mostly happening.

In fact, if you look at the trade-weighted euro, you can argue that financial conditions in the eurozone remain relatively tight even after one round of quantitative easing and more needs to be done to loosen them up.

But there is some good news too. Philippe notes that while a more severe drop in emerging markets would have significant consequences on commodity prices and currencies, developed markets are less dependent on emerging markets than on other developed markets (click on image):

What else? Philippe notes that while he prefers U.S. government bonds over European ones, in the corporate market, the fundamentals of European credit are better than those in the U.S. (click on image):

[Note: I highly recommend you contact Philippe Ithurbide, who was head of Fixed Income at the Caisse before joining Amundi as their Head of Global Research, to see his entire presentation which is truly excellent. You can reach him at and you can view Amundi's latest research comments here].

This brings me to an important point, just how successful is the ECB in promoting growth in the eurozone? That all depends on who you talk to. In his critical comment in Forbes, economist Steve Keen comments on The Power And The Impotence Of The ECB:
I’ve attended two conferences in two days where both the power and the impotence of the European Central Bank (EBC) have been on vivid display.

Its political power is considerable, both in form and in substance. At both seminars, the ECB speaker—ECB Board member Peter Praet at the first, and ECB President Mario Draghi at the second—spoke first, and then left. In substance, the ECB has no need to defend its policies because it is unimpeachable in its execution of them. In form, it does not even considering engaging with its subjects—I use the word deliberately—in open and robust discussion.

It’s not unusual for a political leader to turn up at an event, speak and then immediately leave. But even political leaders have to tolerate sometimes being savaged by fearless CNBC moderators when they speak in public. And I expected that economic leaders would want to hang around and get some feedback—positive or otherwise—from the economic elite that gathered to hear them. Might they not learn something about why their policies weren’t working as they had expected them to?

Not a bit of that for the ECB. There was plenty that could be criticised, even within the context their speeches set. Speaking at the FAROS Institutional Investors Forum, Praet acknowledged, numerous times, that the ECB had failed to hit many of its policy targets—in particular, he noted how many times the ECB had to put off into the more distant future its objective to return to 2% inflation. But there was no chance to challenge him as to why they had failed, because after a couple of perfunctory exchanges with the moderator, he was out the door.

At the more prestigious Frankfurt European Banking Congress Draghi stated bluntly that the ECB would continue to do all it takes to support asset markets via QE—in the belief that this supported the real economy. This was a declaration of the intention to use unlimited power—since there is no effective limit to the ECB’s capacity to buy assets from the private sector.  A politician would have to respond to sceptics about the use of such unlimited powers. But there was not even a single question, nor even a murmur, from the audience.

There was however a jolt of recognition. Draghi was going to continue supporting asset markets, and that was that. The King spoke, the subjects listened, and The King left. There was nothing his subjects could do about it but cope with its consequences.

German Finance Minister Wolfgang Schäuble, who book-ended the EBC conference, had no such luxury of freedom from interlocution—nor did he need it. He engaged in a lively banter with his interviewer as he defended the far more limited power he has over expenditure in Germany. I doubt that Schäuble will suffer electoral defeat any time soon, but unlike Draghi he faces the prospect that it could happen. That doesn’t make him any less resolute in defending his policies; it just means that he has to defend them.

This is what the originally principled concept of “Central Bank Independence” has transmuted into. The promise was that the economy would be spared the disturbances caused by politicians making economic decisions on political grounds: “pork-barrelling” would be a thing of the past, and we would all be better off for it, for two reasons. Firstly, vital economic decisions would be made without consideration of political advantage. Secondly, the people making those decisions would be economic technocrats, who know how the economy works and would therefore make decisions that made rampant economic instability a thing of the past.

This is where the ECB’s power gives way to impotence. The ECB can cower politicians and the public with its unlimited monetary powers. But it can only make the economy dance to its tune if it knows how the economy works, and can duly pull the requisite levers to keep the economy on an even keel.

Clearly the ECB does not know how the economy works. Not only did it—and all other Central Banks—not anticipate the crisis in which it is now embroiled, its policies to try to restore what it sees as normal (unemployment of about 5-6% and inflation of about 2%) have thus far failed. Even on their most favourable forecasts, the Euro region won’t achieve its pre-crisis level of output until early 2016. Not only does this make the crisis far longer and deeper than any post-WWII European downturn, it also underscores how poorly Europe has performed compared to the USA. There the 2008 crisis also ranks as the longest and deepest downturn, but the USA returned to pre-crisis output in less than half the time that the Europeans hope that they will end up doing.

The ECB is not alone in being granted political independence by politicians who, more likely than not, were happy to pass the poisoned chalice of making interest rate decisions to bureaucrats than to hold itself themselves in the days when inflation was rampant and increasing interest rates to control it aggravated voters. The US Federal Reserve also has independence. But in the USA, all it would take to overturn it, as a failed experiment in economic management, is a vote in Congress. In Europe, an entire new treaty between all 19 member states of the Euro would be required.

The ECB therefore resembles nothing else if not the unaccountable monarchies whose failures to serve the common good led to its revolutions in the 18th and 19th centuries. Laughably, Peter Praet claimed that the ECB was accountable if it failed to meet its objectives—as he admitted it had:
"At the same time, a central bank cannot allow itself too much discretion over the time horizon when inflation should return to its target. A numerical objective which is rarely realised – looking forward and in retrospect – is no hard objective. Our independence rests on the fact that we are accountable, and that means delivering price stability over a horizon that is verifiable by the public."
How are they accountable? They don’t have to answer to any national parliament as the Federal Reserve does—in fact the ECB charter expressly says that it is unaccountable:
"Neither the ECB nor the national central banks (NCBs), nor any member of their decision-making bodies, are allowed to seek or take instructions from EU institutions or bodies, from any government of an EU Member State or from any other body."
Not only are the unaccountable in statute, they have become unaccountable in behaviour as well. What politician could admit to the raft of failures for which the ECB is now responsible, and leave a public conference without answering a single question, nor having to consider an opposing viewpoint—such as the one I gave immediately after Praet at his conference?

Unaccountability with success is one thing. Unaccountability with failure, as the ECB and the entire economic apparatus of the European Union is delivering to Europe, is another altogether. Such impasses have not worked out well in the past—especially in Europe.
I'd like all you eurozone bulls to chew a bit on Steve Keen's thoughts as well as others (including me) who are skeptical on the eurozone's long-term prospects even as the ECB gets ready to ramp up QE2 over there.

Below, ECB boss Mario Draghi discusses why they are getting ready to ramp up quantitative easing to bolster euzone's inflation. I don't think the ECB will successfully engineer higher inflation in the eurozone but more stimulus should bolster risk assets in Europe and around the world.

I also embedded a Le Monde interview with French economist Thomas Piketty that took place in July where he discussed what needs to be done to bolster the Greek economy and avoid a protracted debt deflation crisis in Europe (interview is in French but it's excellent and well worth listening to).

On Friday, Amundi's Philippe Ithurbide told us that Greece is like a boomerang that keeps coming back every two years. I think he's right and the eurozone will be lucky if the Greek boomerang doesn't come back to haunt the region, especially if the deflation crisis gets much worse.

But it's not just Greek banks I'm worried about, it's also Italian ones which are still struggling with a mountain of soured debt, with non-performing loans rising to 200 billion euros in September from 198 billion the month before, prompting the Italian central bank to launch $3.19 billion new fund to rescue banks.

All this to say the ECB doesn't have much of a choice but to continue with more quantitative easing to reflate assets in an attempt to lift eurozone's inflation expectations. This is what all central banks are doing as they push forward to save the world. But something tells me in Europe, it's too little, too late, and Mario Draghi's worst nightmare might become a reality, one investors aren't pricing in yet.

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