Is the EU turning Japanese?

So much for outgoing European Central Bank President Mario Draghi’s ‘big bazooka’. The Italian had talked a big game over the summer but that had only served to ratchet up the expectations of financial markets that would always be greedy for more cheap cash, no matter how much you gave them. In the end, Signor Draghi provided:

  • a 10 basis point (0.1%) cut in the deposit rate to -0.5%, charging banks more to park their cash with the European Central Bank (ECB), in an attempt to get them to lend

  • a resumption of Quantitative Easing (QE) scheme – this time Draghi and his fellow board members at the ECB sanctioned €20 billion-a-month programme, without any time limit.

  • ECB continues with its unorthodox monetary policy experiment

    Source: ECB, FRED – St Louis US Federal Reserve database, Refinitiv data

    Yet market reaction was initially muted. Bond prices fell (as yields rose), equity markets did little and the euro went up against the dollar.

    This is the opposite of what Draghi would have wanted to happen, to suggest that markets had felt he had pulled out a spud gun rather than a bazooka and that faith in his policies has begun to ebb. The EU’s economy has proved able to stand on its own two feet for barely nine months, as it was only last December that the ECB stopped adding to QE.

    More to do

    An inflation rate of 1% is way below the 2% target and economic growth across the EU is still anaemic – the ECB cut its forecasts again, alongside Draghi’s policy announcement. The euro has lost 10% of its value against the dollar, even if has gained 14% against an enfeebled pound since the ECB President first swore he would do ‘whatever it takes’ to defend the single currency on 26 July 2012.

    Even European share prices seem unconvinced, which must be particularly galling for an ECB President who once said that the first thing he looked at in the morning was stock markets. Yes, the Euro Stoxx index is up by 75% since Draghi’s commitment to the euro. But at 383, the benchmark equity index is no higher now than it was in December 1999 and the Euro Stoxx banks index is back at 1993 levels. This has very uncomfortable echoes of the ‘lost decades’ suffered by Japan since the bursting of its debt-fuelled property and stock market bubble in 1989.

    Europe’s key stock indices have not progressed for 20 years – or longer

    Source: Refinitiv data

    Draghi can hardly be held responsible for the overbanked nature of many European markets, the fragmented state of EU bank industry (which means too many players lack scale) or bank bosses’ reluctance – or inability – to clean up their balance sheets and tackle non-performing loans as ruthlessly as the Americans did a decade ago.

    But the slide of the banking index in particular is a concern and even Draghi himself seems to be finally recognising that his negative-interest-rate policy (NIRP) and QE may be doing as much damage as good. Last week he moved to exempt some of European banks’ excess reserves from the -0.5% deposit rate to at least acknowledge this risk.

    The ECB wants banks to lend. But by charging them -0.5% on their excess reserves, the central bank is compressing margins and eroding capital bases, limiting banks’ ability and desire to lend. By contrast the US Federal Reserve is still paying interest to American banks on their excess reserves, helping to support margins, buttress capital bases and facilitate lending.

    Cheap at the price?

    It is therefore easy to paint a gloomy picture. But some advisers and clients may take the view that little or none of this constitutes ‘news’ and that if an index is where it was 20 years ago, there may be some contrarian value to be had.

    The good news is that European stocks do trade at a discount to some of their global peers, although less encouragingly this is not unusual if you look back over time, especially relative to the all-conquering US equity market.

    Data from Bloomberg does, however, suggest the Euro Stoxx is cheap relative to its own history on certain earnings and yield metrics. That may tempt some but it also begs the question of what will prompt investors to reappraise Western Europe as a portfolio option.

    Europe looks cheap relative to its own history and global peers

    Source: Bloomberg data

    A settlement to the vexed issue of Brexit is one possibility but that would still leave the EU facing fractious regional political issues in Belgium, Spain and Italy to name but three. Some improved economic momentum would be very helpful, if the bloc is to really shake off the ‘Japanification’ tag, especially as that would also soothe unhappy electorates.

    Time-pressed advisers and clients are hardly short of indicators when it comes to the EU’s economic health but this column’s favourite remains Belgium’s Courbe Synthétique.

    Source: National Bank of Belgium, Refinitiv data
    The value of investments can go down as well as up and your client may not get back their original investment.

    For whatever reason, the survey of several thousand Belgian industrials has an uncanny long-term link with the Stoxx Europe index and – even if the past is no guarantee for the future – it will be worth watching. The Courbe is on a run of five straight falls and the next monthly survey result is due on Tuesday 24 September.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.