On Thursday evening, it seemed all was lost for the eurozone.
Mario Draghi had sworn to do “whatever it takes” to save the euro. Then on Thursday afternoon, he did nothing. He just talked.
With the ‘big bazooka’ failing to materialise, markets plunged, as you’d expect. The European Central Bank (ECB) had failed.
But then on Friday, yields on Spanish and Italian debt fell, and markets rebounded sharply. Suddenly the end of the world didn’t seem quite as nigh.
So what’s changed everyone’s minds?
The politics of the eurozone are still tilted against bail-outs
A couple of things cheered investors up on Friday. Firstly, when the US payrolls data came in, it was a lot less awful than it could have been.
But more importantly, markets started to reconsider what ECB head Mario Draghi had said on Thursday.
Everyone had been hoping for some new big bond-buying package. Or maybe another bout of LTRO (Long-Term Refinancing Operation). Or maybe even some quantitative easing (QE).
What they got instead was a lot of talk. And that shouldn’t come as a huge surprise.
The politics of the eurozone are still tilted against ‘solutions’ involving money-printing. To recap, the easy way out of this crisis in the short-term is for the ECB to print euros and buy bonds. This is exactly what both the Bank of England and the US Federal Reserve have been doing.
The Fed and the BoE are doing it ostensibly to try to push inflation higher. But it also has the effect of keeping your bond yields low (because the central bank has unlimited buying power) and keeping your currency weak too.
With the eurozone, of course, it’s more complicated. Because the ECB would only be buying certain bonds – those of the troubled countries. But the inflationary impact of printing money would be strongest within the least-troubled countries – like Germany.
So the Germans are being asked to accept more inflation than they’d otherwise have in exchange for bailing out the periphery. They’re none too happy about that idea.
You can see why. Bond yields in ‘periphery’ countries are rising partly because the structure of their economies is fundamentally flawed. Greece is by far the worst offender on this score. But one way or another, they could all do with getting their houses in order.
So the Germans don’t want to give these countries a free ride. There’s no incentive for them to change otherwise.
That’s all very well, and it’s easy to sympathise with the German point of view. The problem is that no one in the eurozone – not even the Germans – wants the euro to break up. If you push austerity too far, chances are one or more countries will end up quitting. Not every nation is as stoical (or perhaps it’s more accurate to say ‘comfortable with mass emigration’) as Ireland is.
Greece came very close to dropping out at the last election. And I suspect that the eurozone is now ready and willing to countenance a Greek exit. The euro could conceivably survive without Greece, if it was prepared.
But a Spanish exit? An Italian one? Forget about it. An exit by either of those two would demolish the euro in its current form.
So while the austerity brinksmanship makes sense with a country like Greece, it’s pretty hard to pull off with the bigger players.
The European Central Bank is planning to buy more bonds
That’s why it’s interesting to look more closely at what Draghi said on Thursday.
As Ambrose Evans-Pritchard reports in The Telegraph, Draghi noted that the ECB may “undertake outright open market operations” of “adequate size” to cap bond yields for troubled countries that are pushing through reforms.
“ECB experts [will] draw up plans… for potentially ‘unlimited’ and ‘unsterilised’ intervention in the bond markets,” writes Evans-Pritchard. In other words, Draghi “basically said that he was considering QE,” as Gary Jenkins of Swordfish Research told the FT.
Julian Callow of Barclays Capital agreed: “Draghi has made it clear that the ECB is preparing to buy Spanish and Italian bonds on a much bigger scale. This is the thin end of the wedge for QE and marks a turning point in the crisis”.
There’s a catch. Troubled countries have to sign up to the EFSF (the big bail-out fund). So they have to ask for a formal rescue package, which will mean signing up to reforms, and no doubt stricter supervision.
In other words, what Draghi is saying is this: if you show that you’re capable of being a good European, the ECB will print money to buy your bonds. That’ll cap your borrowing costs, and tide you over while you restructure your economy.
That’s pretty radical. And you just need to look at the reaction of the Germans to realise that. Jens Wiedmann, who represents the German Bundesbank on the ECB board, voted against the idea of buying periphery bonds. But he was outvoted.
As Olaf Storbeck in Handelsblatt put it: “Between the lines the message was perfectly clear. The Bundesbank might not like it, but the ECB will intervene in the bond markets in the foreseeable future. And big time.”
Europe looks cheap if utter disaster is avoided
In short, the real significance of Draghi’s speech is that it was another step down the road towards full-blown QE for the eurozone. That’s very significant for investors.
Don’t get me wrong. QE is not a cure-all for Europe’s woes, just as it’s not a magic cure for Britain’s or America’s. It’ll bring its own set of problems.
But the point is that for now, most of Europe is priced for a much nastier outcome than that. The main thing keeping European stock markets much cheaper than the rest is the threat of a messy break-up for the eurozone. QE would make that scenario far less likely.
As Ben Inker of highly-respected US value investor GMO noted last month, eurozone equities (excluding financials) are “about 15% cheaper than fair value.” This “broadly [discounts] an ugly endgame for the region. If something less bad than that occurs, the stocks are at least mildly cheap.”
We’ll be looking at the eurozone again in more detail in the next issue of MoneyWeek magazine (if you’re not already a subscriber, you can subscribe to MoneyWeek magazine). But we’d say again that – if you haven’t done so already – it’d be a good idea to start allocating a bit of your portfolio towards Europe.
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