Today investors were sent into an unjustified optimistic frenzy by a new bond buying plan announced by the European Central Bank (ECB). While some liken the plan as a bold gambit that will save the European Monetary Union (EMU) from certain dissolution, from our perspective it seems likely that without significant fiscal support from the surplus nations (like Germany and the Netherlands) the bank will accomplish little more than spinning its wheels. And while there is no certainty that such support is forthcoming, any support that does materialize will likely not be in a form that will provide any short-term boost for the stock market.
ECB President Mario Draghi said that the Bank could now buy unlimited quantities of bonds of member states on the secondary market in a maturity band of one to three years. The important stipulation, however, is that such activity will occur only if there is the possibility of parallel bond buying on the primary market through the European Stability Mechanism (ESM) or European Financial Stability Facility (EFSF). The ECB is signaling that it is unwilling to put its neck on the line unless there is some type of guarantee from EMU member states that either the ESM or the EFSF will finance the repayments of the interest and principal on the debt the ECB acquires. Without this primary market financing, the ECB’s bond buying will do nothing to address the fundamental crises of the beleaguered countries and would needlessly expose the ECB to large losses. This clumsy workaround results from the prohibitions of Article 123 of the EU’s Lisbon Treaty, which imposes clear restrictions on the direct ECB financing of member states. There is a broad consensus that direct ECB purchases of bonds would violate these provisions.
In addition to the conditionality above, Mr. Draghi also said that under the new program, buying would commence only if country-specific deficit reduction targets are designed and monitored by the International Monetary Fund. That is decidedly not a positive for equities. If there are austerity conditions attached to aid, the nations receiving the assistance will almost certainly remain in, or slip back into, recession. This has been the base case for the European economy all along, and it appears nothing has changed.
In summary, the ECB has now agreed to buy European bonds on the secondary market if member states agree to finance their peer’s deficits, and if the states receiving aid agree to austerity. This keeps the problem, as it always has been, an issue of fiscal policy not monetary policy. It’s important to note that nothing has changed on that front. Surplus nations still maintain the conditions that will be attached to any assistance, and deficit nations are reluctant to agree due to the pain such requirements will impose on their economies. Whether the two sides will be able to settle their differences remains to be seen, but in either case, a clear way forward is far from solved.
We can assume that, in the end, assistance will be given. But it will come with the types of attached strings that lead to slower than trend GDP growth over the many years it will take before the excesses that have been built up in the past are cleared. Ultimately this is healthy for Europe, and a long-term positive for the currency and economy. In the short-run however, it’s likely negative for European stocks and will likely have an adverse impact on GDP growth.
Jim Nelson, CFA, is Portfolio Manager with Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
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