The Impact of Q.E. on the Eurozone

By Chetun Patel, Head of Mariana Strategy, Mariana Capital On 5th March 2015 Mario Draghi, president of the European Central Bank, categorically stated that Quantitative Easing (QE) was already impacting the Eurozone (EZ) economy even as the press conference he was speaking at was to action the first buying of the QE programme. Was he right and if so is it sustainable? In Draghi’s most recent press conference on the 15th April 2015 he was clear about the motivation to pursue such an unconventional path. He asserted that it was to achieve ‘a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium-term, a clear statement that deflation was the primary driver. The combination of slowing global growth, a savings glut and the crisis in business and consumer confidence triggered by the financial crisis of 2007-08 pushed global inflation rates lower. However, it was the recent collapse in oil prices accelerated by OPEC that was responsible for the last escalation in deflation fears in the EZ. Hence, if deflation is then considered a barometer then Draghi’s claims that QE was already impacting positively can be validated by looking at the improvements in the proxy real rate of return (Ten Year rate – Ten-year breakeven rate). Chart 1 highlights the trend established this year when the ECB began talking up the fact QE was part of their policy toolkit. The increasingly negative rate is a reflection both of falling interest rates but more importantly the rise in breakeven rates, in effect a stabilisation of inflation expectations. The other major positive that the ECB has highlighted has been the improvement in liquidity conditions that has created a more favourable environment for lending. It is evident that the ECB through a number of unconventional monetary measures have added significant liquidity to the economic system but as chart 2 illustrates it is only recently that we have seen significant upward trends in both M1 and M3 measures simultaneously, something that has not occurred since the onset of the financial crisis. This has resulted in easing external financing levels to the private economy and in particular the borrowing conditions for firms and households. In understanding why Draghi has reason to celebrate, how can we expect this story to evolve? Namely, beyond stabilising expectations can we determine the impact on the real economy? The real economy in the Eurozone has improved as evidenced by a number of economic data points led by the clear rise in Eurozone GDP since the beginning of 2013. In breaking the GDP numbers down it can be noted how well it correlates with the improvement in domestic demand as shown in Chart 3. This chimes with the fact that despite the weakness in the EZ during 2012-13, global GDP did not soften significantly suggesting that external factors were not primary triggers. It has been internal factors that have driven European markets with domestic demand being the key determinant. Delving deeper it becomes apparent that the consumer across Europe has begun to feel increasingly confident (see chart 4) and this has fuelled the pick-up in domestic demand. Since 2013, all the major Eurozone countries have enjoyed an upturn in stark contrast to the weakness observed since the sovereign crisis that emerged in 2010. This illustrates the importance consumer confidence has played in the Eurozone crisis and requires us to offer an explanation for its rise. As we mentioned earlier the ECB has become increasingly active and that has led to the improvement in liquidity conditions, accelerated by the announcement of the bond-buying programme. Furthermore, we have seen improvements on the fiscal-side with austerity easing (see chart 5). During the worst of the sovereign crisis in Europe, periphery countries were suffering from a worsening fiscal/monetary mix in which austerity was being pushed as liquidity conditions remained relatively tight. However, the situation has turned around with Spain having seen the most significant improvements in their economy having benefitted the most from easing in austerity terms in percentage terms (see chart 6) supplemented by the additional liquidity offered by the ECB which led to a collapse in their funding rates. This bullish change in the environment has been core in improving business and household confidence. In summary, Draghi was correct in stating the QE is working and it has been since the beginning of the year. Inflation expectations have stabilised and the threat of deflation has been averted in the short-term. Simultaneously, the economic picture within Europe has improved as household and business confidence has been restored. The key to this has been the ECB who under Draghi reassured markets that ‘they will do whatever it takes to save the Euro’. They have been true to their word and with it helped the real economy achieve real growth. They have been able to improve the fiscal and monetary mix that had acted as an anchor the Eurozone economy through ultra-low rates providing time and room for governments to slacken austerity measures. It seems that finally Europe is in a position to grow however it has taken monumental efforts by the ECB to make the euro work. The fear is that with so much capital spent over the past few years, there remains little in the bank to avert further troubles such as that we are currently seeing with Greece. The ECB has done a wonderful job of crisis management but essentially is the idea of a fiscal and monetary union a futile task?