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European Central Bank: Looking for Silver Linings in Disappointment
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Market Pulse
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März 13, 2020
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European Central Bank: Looking for Silver Linings in Disappointment
European Central Bank: Looking for Silver Linings in Disappointment |
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The initial market response to the European Central Bank (ECB) meeting on March 12th was disappointment – equity prices fell while Bund yields rose. But the ECB actually delivered nearly everything analysts had been expecting from it:
• An additional funding scheme (long-term refinancing operation (LTRO)) for small and medium businesses,
• An easing of bank capital buffers (to facilitate greater bank lending), and
• A EUR 120 billion increase in the ECB’s asset purchase program (i.e., quantitative easing) programme for the rest of the year.
However, it did not deliver an interest rate cut (which is the main reason why Bund yields rose). This possibly reflected the belief that further rate cuts into ever more negative territory would not help the economy, although ECB President Lagarde dismissed the idea that the ECB is at the “reversal rate” (the rate at which the negative consequences of further cuts more than off-set any benefits).
There was also a significant faux pas on the communication side: While the package should have been supportive of credit spreads (both sovereign and corporate), President Lagarde’s comment that it is not the ECB’s job to “close bond spreads” pushed sovereign spreads sharply wider and suggests she failed to recognise the extent to which investors were looking for reassurance that the ECB would guarantee the orderly functioning of financial markets. The ECB has always been sensitive to the suggestion that it may be providing undeserved support to profligate borrowers, but supporting the integrity of the Eurozone financial system is central to its mandate.
What the ECB really failed to deliver, and what it could not do by itself, was a coordinated fiscal and monetary policy response to the growing coronavirus epidemic and its economic consequences. ECB President Lagarde has been calling loudly for such a response for some time now, and reiterated these views again today. However, she has limited power in coercing European governments to come up with such a plan, and experience has shown us that the European Union (EU) tends to be slow in responding to crises in such a coordinated manner, even if it usually gets there in the end.
But the EU is far from the only region where the official policy response to the coronavirus crisis has been jerky and often piecemeal. In fact, the United Kingdom was a rare exception earlier this week in delivering a combined fiscal and monetary response; ad hoc, disjointed policy responses have been more typical. With the global peak in infections most likely still some months away, and medical experts suggesting a viable vaccine is likely to take even longer, investors are likely to remain cautious, and markets volatile, until policymakers can show they are getting in control of the situation.
We suggest maintaining a defensive asset allocation in portfolios, holding high quality government bonds to provide a measure of ballast to portfolios and generally resisting the urge to buy, just yet, risky assets that are now looking cheap relative to history.
However, the March 12 ECB decision and press conference also suggest some particular investment opportunities for euro fixed income investors. In particular, the EUR 120 billion increase in the ECB’s QE programme will provide it with significantly more firepower to support markets. In addition, President Lagarde suggested it would use the “full flexibility” of the programme and that these purchases would be skewed towards the private sector, and other non-governmental bonds.
There are three reasons why the ECB would want to skew purchases towards the private sector:
1. Buying less government bonds is politically easier for it (as it avoids the accusation of funding governments directly);
2. ECB studies suggest buying private sector bonds has a bigger impact on the economy; and
3. ECB buying may support the smooth functioning of the corporate credit markets, keeping an important source of financing open to European corporates.
Today’s announcement should therefore be supportive for the European corporate credit. It remains unclear if the ECB will be prepared to move beyond buying non-financial investment grade corporates. In the past the ECB has been careful to have as little price impact as possible on the market when it has been buying, but having a larger buyer-of-last resort should still be supportive for the market.
The other assets which we think should benefit from today’s announcement are European supranational, government agency and regional government issuers. Many of these are eligible to be purchased instead of government bonds, which is handy for the ECB when it comes to sovereigns like Germany, where it owns nearly as many Bunds as it is allowed to (under its self-imposed rules). These high quality issuers are currently offering an unusually large yield pick up to sovereigns, and hence offer investors some potential for spread compression while still being high quality, defensive assets.
Risk Considerations
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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Executive Director
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