Can the ECB Offer a Quick Fix for the Crisis in 2012?
In 2011 investors had a lot to worry about. The euro zone crisis, credit rating downgrades, slowing growth, crisis in North Africa and the tragic nuclear and natural disasters which hit Japan all led to a relentless 12 months of market volatility.
Those returning to work this morning are wondering whether the volatility continues and whether the euro zone debt crisis will continue to drive it.
It remains to be seen if the euro zone and its policy makers can find a meaningful solution to a crisis which has taken down governments, driven borrowing costs to unsustainable levels in the euro zone’s periphery and reignited fears of a banking crisis.
Having given a boost to market confidence in December by pumping nearly half a trillion euros into the banking system while snapping up billions of euros worth of peripheral bonds in the secondary market, Mario Draghi, the President of the ECB , gave the market some breathing space over the holiday season.
The ECB intervention has helped ease market tensions, lowering borrowing costs for Spain and Italy while helping to boost stocks in the last few weeks of the year.
The question facing investors in 2012 is whether the ECB — by offering cheap money in return for risky assets held by the banks and buying up Spanish and Italian bonds in the secondary market — offers the beginning of a lasting solution to the debt crisis or it has simply put a plaster on things for a couple of weeks.
Billions of euros worth of debt from the banks and euro zone governments need to be refinanced over the first few months of the year and Draghi himself said in December this will bring things to a head.
“The pressure that bond markets will be experiencing is really very, very significant if not unprecedented,” said the ECB boss. The action he took to restore calm in December has helped, but it is very difficult to say whether the central bank will save the day.
“The outcomes here are binary: we could see a worst-case scenario of a collapse of the euro zone and a severe credit crunch, but also a world in which the ECB starts large-scale quantitative easing and Germany agrees to issue [joint euro zone] Eurobonds,” Garry Evans, the chief global equity strategist at HSBC wrote in a research note on Tuesday.
Earnings in Focus
Evans sees only 2 percent upside for stocks in 2012 and is focusing his attention on earnings, strong balance sheets and exposure to structural growth. None of this indicates Evans has huge confidence as the year gets underway.
Carl Weinberg, the chief economist at High Frequency Economics says Draghi’s actions are a positive but he warns investors they need to understand that “policy cannot stabilize the bond markets.”
“Policy can only hope to protect the banking system from the consequences of a bond market meltdown,” said Weinberg in a research note on Tuesday.
Noting the good work the ECB’s action has done Weinberg believes policy makers now need to properly fund the euro zone's rescue fund — the European Financial Stability Fund — with enough firepower before the liquidity created by the ECB “flees abroad to a safe haven.”
He wants the EFSF to start issuing bonds which banks can buy with the recent liquidity boost from the ECB. The risk if they do not is money sitting in the ECB’s overnight deposit window rather than finding its way into the real economy.
Others, like David Jones, the chief European financial economist at Jefferies, believe the threat of deflationary pressure will allow the ECB to engage in quantitative easing under article 105 of the Maastricht Treaty.
The article states that the euro zone's central bank can support "the general economic policies in the Community" as long as this does not prejudice its primary objective, that of maintaining price stability.
If deflation on a two-three year view became likely, Jones believes German opposition to quantitative easing could be overcome.
“This neatly gets around the ECB’s problem of not wishing to be seen on legal grounds for even indirectly helping finance a sovereign, but would only be justified because the macro outlook was so poor, deflation risk was rising and they had run out of alternative conventional measures,” said Jones.
With austerity cuts across much of Europe already leading to low or negative growth rates, it is unlikely that any euro zone member will be growing their way out of debt in 2012.
“The euro zone crisis is life threatening because there is too much debt, too little growth and huge intra-zone trade imbalances belated resurrection of fiscal rules is no panacea,” David Simmons, the head of FX strategy at RBS said in a 2012 outlook note in December.
“We are in a multi-year deleveraging world with multi-year low growth consequences, so mistrust most the quick fix, free liquidity addicts who seize on each emergency monetary policy response as a cure-all,” Simmons added.