IT’S SUPER MARIO!
The eurozone may still be deep in the mire, but, savvy ECB head Mario Draghi is providing some reasons to be cheerful, says Guy Monson
MARIO DRAGHI IS proving to be a surprising friend of global markets, with world equities up by more than 10 percent (or above 20 percent for a euro-based investor) since his appointment to the ECB in November 2011. Most of the gains came in the aftermath of his big policy announcements, namely, the first round of his trillion-euro LTRO programme last December, and more recently in his ‘whatever it takes’ speech in London in July.
While none of these actions alone is a panacea for restarting European growth, Draghi’s pledge of co-ordinated action has calmed markets with its technical competence, political guile and tentative roadmap for ECB intervention and (perhaps ultimately) fiscal union.
In fairness to his ECB predecessor, Jean-Claude Trichet, the eurozone prior to Mr Draghi laboured under a political structure largely unreformed and unmodernised since the euro was formed in 1999. Still, Mr Trichet’s passive acceptance of the status quo and reluctance to embrace a broader role for the ECB unnerved investors.
By contrast, Draghi has combined some very practical banking skills with diplomatic savvy and an effective communications strategy to push the ECB into previously uncharted territory without unsettling markets. In August he announced that the ECB was going to purchase shorter dated securities of troubled sovereigns, but only after a country has formally requested assistance.
By attaching conditionality to ECB support, he addressed the moral hazard concerns of politicians in core Europe implicitly stating that while the ECB still has tools at its disposal, there is no such thing as a free lunch. The strongest signal, of course, came when Draghi said that it was in the remit of the ECB to remove the convertibility (or break-up) risk premia in European assets, potentially implying that full-scale quantitative easing may no longer be unthinkable.
Meanwhile, downgraded inflation figures and growth forecast cuts in the quarterly inflation report mean the Bank of England also has the potential to pursue more quantitative easing.
AGAINST THIS BACKDROP, ‘yield assets’ will continue to be attractive, as financial repression caps cash and government bond yields at levels well below inflation. Central banks’ actions have compounded the unfolding European crisis, driving two-year government yields into negative territory in half a dozen European countries, including Switzerland and Germany.
Corporate bonds have been one of the main beneficiaries of this economic environment, which has also been marked by private sector deleveraging, soaring government deficits and ageing populations. With short-term safe-haven assets now yielding next to nothing, credit should continue to experience enduring fundamental support. In particular, I believe the move to tighter and tighter blue-chip corporate credit spreads is almost inevitable, and that lending to profitable companies with strong cash-flow could be the more ‘gilt-edged’ investment for some time yet.
The property market is another natural winner of a low-interest rate, ‘search for yield’ and ‘flight to safety’ environment. Since the lows of 2009, the listed real estate sector (mainly REITs) has come a long way; as one of the first sectors to recapitalise, it has benefited from the perfect storm.
Indeed, quantitative easing has pushed up the demand (and therefore the prices) of real assets and significantly reduced financing costs to very attractive levels. On top of that, due to negligible or negative real yields in safe-haven bond markets today, investors searching for alternative assets to match liabilities have looked favourably on prime real estate due to its secure and visible cash-flows. Finally, construction has remained at record low levels in most regions, as speculative development financing remains hard to obtain, maintaining favourable supply and demand dynamics for the industry, which has helped to improve occupancy and rental levels.
In other words, with the potential for further QE and the yield spread of listed real estate versus its local ten-year bonds still near record high levels, investors will continue to perceive REITs as credible ‘bond alternatives’.
SO WHAT EXACTLY does the Draghi effect mean for global investors? First, monetary policy seems likely to be loosened further; in the face of what is already an attractive equity market. Second, profit growth will be challenging as GDP growth slows, a European consumption shock ripples through margins and rising commodity and labour costs impact emerging world profits. In other words, investors will have to rely disproportionately on equity multiples expanding rather than earnings rising. This is not unreasonable, given the generous equity risk premium available and the absence of yield elsewhere, but leadership in markets will change.