Luca Paolini, Pictet Asset Management

ECB enters uncharted territory

Luca Paolini, Chief Strategist at Pictet Asset Management, comments on the ECB monetary stimulus changes and asset allocation response…

These measures represent a significant easing of policy, bold moves designed to take the market by surprise. The ECB is now acting on pledges it made some time ago. In one sense, the shift in stance is an attempt by the ECB to ditch its reputation for being ‘behind the curve’.
 
The combination of negative deposit rates and the non-sterilisation of bond purchases should further weaken the EUR in the medium term, which is key to ending deflation. However, the currency would be much more responsive to full-blown quantitative easing. In this respect, we draw some comfort from the fact that Draghi clearly left the door open to QE, even if he did not specify the conditions under which it would be undertaken. In our view, the pre-condition for QE would be a substantial cut in the ECB’s inflation forecast for 2015, which is currently 1.5 per cent.
 
Quantifying the liquidity boost, the ECB could provide an estimated EUR 565 billion of additional support (EUR400 billion of which through its TLTRO and EUR165 billion from its move to leave bond purchases unsterilised). According to our own liquidity analysis, we estimate this is nearly three times the minimum amount of liquidity required to reverse a slowdown in money supply.
The net infusion of liquidity is not only positive for Europe – it will also boost liquidity conditions worldwide.
 
The credit easing via the conditional TLTRO has the potential to repair the monetary transmission mechanism, boosting the flow of credit to the real economy by incentivising banks to lend to non-financial corporations.
 
That said, a similar scheme in the UK has met with mixed success. The Bank of England’s Funding for Lending Scheme – launched in 2012 – may have led to a fall in borrowing costs but has so far failed to boost net lending: the volume of business loans is contracting. Most of the improvement in lending has been in the mortgage sector.
 
What is more, while the latest ECB survey showed evidence of improving demand for business loans, the upcoming bank Asset Quality Review will likely discourage European banks from making loans in the short term. It will probably be some time, then, before the ECB’s credit easing measures bear fruit.
 
The establishment of an ABS market via the ECB’s bond purchase programme would, meanwhile, go a long way towards ensuring a sustainable private sector recovery, but this is more of a medium-term prospect.
 
From an asset allocation perspective, this shift in policy would, in isolation, encourage us to shift to a more bullish stance on equities. Yet with our readings on investor sentiment suggesting positioning has become overly-bullish, we are reluctant to move from neutral to overweight equity for the time being. We do, however, retain a preference for cyclical sectors.
 
We also keep our underweight stance on European stocks – valuations are already at expensive levels and the asset class is trading at a premium to its global counterparts.
 
Within fixed income, we are most positive on credit, especially high-yield bonds as well as emerging market hard currency debt.
 
We will, however, remain underweight government bonds – not only are valuations expensive but any improvement in the economic outlook looks certain to push yields higher.
 
When it comes to currency positioning, we expect the EUR to depreciate over the coming months – even though the short EUR trade has become a popular one among investors in recent weeks.

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