EUROPE: MIND ON THE MARKET WHILE CHARTING A BETTER WAY FORWARD

In the immediate aftermath, by agreeing to buy Euro 60 billion worth of public and private securities on a monthly basis until September 2016, under its recently launched quantitative easing ( QE ) program, the European central bank (ECB)  has quite clearly distorted the market. Also the initiative has given once in a life time type opportunity to Euro area countries to get their fiscal house in order by borrowing for longer duration and at a record low cost without being able to provide  or required to provide any fundamental justification to the market. And also by showing a willingness to buy European governments debt as low as minus 20 basis points, the ECB is probably attempting to harmonise the cost of borrowing of the EU states. So as a consequence, we are now living in a reality, where Portuguese and Spanish 10 years sovereign bond has a lower yield  than a U.S. Treasury of the same duration.

While the benefits of the QE to the European governments can’t be understated, European financial institutions from the likes of an insurance companies or a pension fund etc, who rely on investment returns to keep their business model sustainable will most likely have to reassess, or redesign their investment model factoring the new reality of low and negative yielding sovereign debt.

The ECB is clearly aiming to push investors out of what is considered safe haven assets, but investors could also opt to very well sell the Euro denominated European sovereign bonds, and instead buy US treasuries as ECB has very limited control over how investors will allocate capital, and the overall directional flow of the capital. Non European companies with stronger balance sheet could also benefit immensely by borrowing at very low rates in Euros, and there are ample evidence of that happening already as more and more companies flock to Euro to raise capital. So there remains an inherent risk with the approach, and capital will likely flow into various asset class outside of the Euro area.

Also in the last couple of years, a sizeable portion of the profits made by euro area based banks came from their sovereign debt holdings, and in the current environment, it will be interesting to see what sort of impact the change in dynamics will have on banks profitability. Although the banks are comparatively in a much better shape than few years ago, they are still struggling to make good money from their traditional day-to-day business.

Going forward, the QE initiative of European Central Bank (ECB) should improve the overall economic dynamics of the Euro Zone, and the signs are that it is in some way or the other heading in that direction. But a QE coupled with ultra low interest rate environment over a longer than desired period  isn’t all NET positive for the general well-being  of the economy. A sustained ultra low interest rate environment over a long period of time can cause misallocation of capital, mis-pricing of risks, and can also easily become addictive without really creating a big jump in the overall economic activity of the real economy. And here is an interesting data that I believe provides an interesting perspective. Based on various reliable estimates, Japanese savers have over US$ 7.1 trillion stashed in cash, and roughly around US $ 300 billion of cash is believed to be literally stashed under the carpet  across Japanese households creating a situation where excessive savings is not being utilised by the real economy as average household aren’t able to get the return they would expect from traditional channels of investments.

There are still a large number of savers who believe in the good old savings model, where a bank provides an attractive return to its clients on deposits. Also more than half of the population of the developed as well as developing world does not actively invests on a regular basis in stocks or bonds so therefore they are unable to reap the benefits of a record high stock market. And their savings get eroded over time through low to almost negligible return on their deposits while a small percentage of sophisticated institutional investors make good money from record high stock markets mostly driven by the easy QE money, which distorts the connection between the financial markets and the real economy.

And even in an economy where a large percentage of the savings comes from the higher valuation of the house prices, if through traditional channels, a saver is not getting decent enough return from the banks, the overall confidence in the economy suffers, and it is one of the reason why the economic data remains somewhat confusion creating volatility in the financial markets.

There are limitations to what a central bank and monetary policy can deliver or achieve on their own without a sound business and investment friendly economic environment. And this is where Europe continues to struggle. Euro zone economy is showing some signs of improvement  but it still has a long away to go.

A Europe where an entrepreneur as a value creator with credible ideas or project  is able to access right capital and start the journey without getting stuck in bureaucratic red tape is still a bit far from becoming a reality. In general, the market is turning optimistic on Europe’s prospect, but the EU leaders as well as the bureaucrats will need to be focused on delivering the essential reforms in order to make sure Euro Zone as an economic growth engine starts to fire, to ensure it stays relevant and competes better. So the European policy makers will need to keep their mind on the market while charting a better way forward for Europe.