Time to Surf the ECB’s Market Wave

For European markets, Mario Draghi has done it again. The European Central Bank president’s indication of further policy easing to come in December has given the green light to investors to take risk.

Mr. Draghi’s latest intervention has come at a time when markets have been wobbly, but the eurozone economy has been relatively resilient. Friday’s flash purchasing managers indexes for October, compiled by data firm Markit, showed a picture of continued domestic demand, with the headline index beating expectations at 54.0 and services providing much of the impetus.

Further easing may in economic terms be little more than taking out insurance against a worse outcome, rather than acting to accelerate growth. But by changing the balance of risks for investors—in particular by driving down the euro and suppressing default risk in aggregate—it should make it more attractive to buy risky securities.

Some of the moves already have been sharp. Markets are pricing in a cut in the ECB deposit rate to minus 0.3%, from minus 0.2% now. The euro, close to $1.15 just over a week ago, is now below $1.11. The short end of the government bond yield curve has collapsed thanks to the indication of a possible cut in the deposit rate.

Remarkably, even Spanish and Italian two-year bond yields turned negative Friday morning; the Italian 10-year spread over Germany fell below 1 percentage point for the first time since March. The Stoxx Europe 600 has broken out of its recent range, and has gained more than 3% since Mr. Draghi spoke; corporate bond markets have rallied.

But there could be further yet to go. With government bond yields going lower again, the search for higher-yielding paper will resume. Investors have cash to put to work, and the potential returns are more attractive than earlier in the year. Euro- denominated “junk” bonds now yield 5.2%, according to Bank of America Merrill Lynch indexes. Monetary easing should help reduce pressure on company balance sheets, although given the advanced stage of the credit cycle, investors will still need to be mindful of the idiosyncratic risks posed by individual companies.

Stocks too should benefit; the lower euro should help flatter European company profits. And buying European stocks may yet be an interesting play for those who think that the emerging-market doom and gloom has been overdone but aren’t quite willing to buy emerging assets outright. Equities aren’t obviously cheap, with the Stoxx Europe 600 trading on 14.8 times the next year’s earnings, according to FactSet; but monetary easing can allow for higher multiples.

The big picture is that even as the European recovery continues, Mr. Draghi has provided more fuel to the market fire. The risk is that he fails to live up to market expectations—but that is a longer-term worry. The same holds for concerns over the ultimate consequences of such loose monetary policy. Tactically at least, it is time to put cash to work.

Source by : wsj


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