Good news for investors in European stocks.
The European Central Bank’s latest plan to save the eurozone has fallen flat on its face. Europe’s banking sector remains mired in fear and for as long as that remains the case, Europe will be at risk of plunging deeper into depression.
That might not sound like a good thing.
But let me explain why it sets the stage for a huge rally in eurozone stocks.
There’s always a willing borrower – willing lenders are the problem
For anyone with a peculiar love of clumsy acronyms, the financial crisis has been the best thing ever. Sadly, that doesn’t include most people, so we’ll try to get through this Money Morning without using too many.
In its efforts to save Europe without launching full-blown, Germany-annoying quantitative easing (QE), the European Central Bank (ECB) made a load of cheap money available to European banks. This was under the targeted long-term refinancing operations (TLTRO) scheme.
Cutting a long story short, the idea was that banks could borrow this TLTRO money for absolute buttons (about 0.15%) – as long as they lent it out to small businesses.
The banks make a big margin on the loan (because they could lend it out for a lot more than 0.15%), small businesses get money, the economy starts to grow again – everyone’s happy.
But it hasn’t worked out like that.
How do you gauge if TLTRO was a success? Well, if banks liked the deal, they’d be biting the ECB’s hand off to get the money. But they’re not. The ECB made €317bn worth available in the latest round. This week we learned that banks took up less than half of that – €130bn.
So why are the banks knocking back practically free money? As the FT’s Lex column points out, there’s a simple explanation.
Banks argue that no one wants to borrow from them. This is the ‘pushing on a string’ argument – and it’s nonsense, as the simple application of common sense will show you. There’s always someone who will take a loan of money from you, given the right conditions. So it’s not that businesses don’t want the money.
The real problem is always with the lender. There simply may be no borrowers around who you would willingly lend to, regardless of how attractive the deal might look. Your willingness to take those sorts of risk will be determined by the state of the wider economy, and the state of your own balance sheet.
And this is very much a problem in Europe right now. The economic backdrop is grim, so companies are arguably more likely to go bust than they normally would.
And Europe’s banks haven’t done much cleaning up of their balance sheets compared to most other developed nation banks. So the last thing they want to do is to take a punt on lending money to risky small businesses. Even if that money came ultra-cheap from the ECB.
A similar thing happened over here in the UK with our various ‘funds for lending’-type schemes. The Bank of England gave cheap money to our banks. The idea (ostensibly) was that they’d pump the lot into dynamic young businesses.
Instead, the banks slashed mortgage costs for buy-to-let lenders (because at least they have an asset to confiscate if everything goes belly-up), and cut interest rates for savers, because they’d found another source of cheap cash.
Of course, ultimately this has helped the banks in some ways by making them more profitable, and therefore more able to get back into a position of health. But it’s not the sort of solution most of us would have hoped for.
The ECB has no choice – it’s eurozone QE or bust
In any case, now that TLTRO has flopped, what does that mean for the ECB? Basically, the ECB has said it wants to lend enough money to drive its balance sheet back up to 2012 levels. But if this continues, repayments of earlier versions of the TLTRO could mean its balance sheet actually shrinks.
Draghi wants to boost the ECB balance sheet by around €1trn. So he’s got a lot of lending to do. So how is the ECB going to pump money out there into this reluctant market? The obvious – if not only – solution is full-blown QE.
Some argue that it won’t work. And the truth is – if your goal is to get banks immediately lending to small businesses again – then they’re right. That’s not how QE works.
What QE does – judging by experience in Britain and the US (and increasingly Japan) – is to inflate asset prices to the point where banks and in many cases, consumers, are no longer dangerously overstretched. That gives them the time to heal, and the confidence to start lending and spending again.
Of course, that’s not necessarily a good thing. Who knows what will happen when the next slump comes along, and plenty of people are still hugely indebted? QE is not an ideal ‘solution’ by any means.
But if your job as a central bank is to keep the money supply growing at a certain rate – and that is basically what a central bank is meant to do – then the only thing left for the ECB is to get going with QE.
That would batter the euro more. But it would also bolster stocks. So we’d stick with the European markets.
It also suggests that the US dollar will have further to rise in the longer run. In the latest issue of MoneyWeek magazine, James Ferguson of the MacroStrategy Partnership looks at the implications of the rising dollar and how you can profit from it. If you’re not already a subscriber, you can get your first four issues free here.
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