When the allies invaded the coast of Normandy on June 6, 1944, no one knew how much was at stake. It was a risky move that not only put an end to years of bloodshed within Europe but also ushered in a new world order that continues today. European leaders are hoping that their central bank’s actions this week will provide an economic D-Day of their own.
The greatest risk to the economies of Europe is deflation. The European Central Bank (ECB) maintains a 2% inflation target for the EU, but the inflation rate as of May was a mere 0.05%. While unemployment remains above 12% and economic growth continues at a sub-par rate, the EU could face an era of stagnation similar to that which had plagued Japan for twenty years.
Over the past three years, the ECB has shoveled over one trillion Euros in loans without conditions to the banking sector. Little of that money found its way to the private sector. Instead, the banks simply re-deposited those funds with the ECB and banked the interest or used it to trade for their own account in the stock and bond markets. In the meantime, lending to the private sector keeps shrinking and the economy stalling.
The ECB has now cut a key interest rate to below zero. It essentially means that European banks in a complete reversal will now be paying the ECB to park their funds there. This negative rate of interest in intended to spur financial institutions to begin lending that money to companies and other credit-hungry entities. The ECB also suspended their sterilization operations (taking money out of the market) which should inject a further 165 billion Euros into the mix.
The bank also promised over $500 billion in discounted loans to banks, providing they lend that money to companies and not other financial institutions. I’d give the bank an “A” for effort, but more needs to be done.
Investors were taken by surprise by the boldness of these latest moves. You see, the markets have long been inured to the actions of the ECB as too little, too late. Unlike the U.S., where our Fed answers to no one, the ECB has to juggle the conflicting views of many member nations of the European Union. While the Fed can take decisive and far-reaching steps to jump-start our economy, the ECB needs to build consensus among its members. This takes time.
This week’s actions are, in my opinion, only the first of several steps to grow the European economy. A quantitative easing program that emulates the asset purchasing that both the U.S. and Japanese central banks have implemented might be the next step. So far, Germany, with its deep-rooted fear of hyperinflation (pre-WWII) has been against this action.
But Mario Draghi, the bank’s president, went on record promising more, if these efforts failed to accomplish his goals. “Are we finished?” he asked. “The answer is no.”
I believe him.
So let’s bring this down to you and your portfolio. Readers may recall that well over a year ago, I suggested some exposure to Europe either through a mutual or exchange traded fund. That has worked out well since European averages, although still selling at a 15% discount to their American counterparts, are all at record highs. I think more exposure to Europe would be a wise move.
Right now, most readers have 25-30% in cash based on my advice. Over the next few weeks, I suggest you move some of that cash to Europe. Exactly how you do that is up to you. Take notice, however, that if the ECB’s strategy works, one can expect the Euro to weaken against the U.S. dollar while their stock markets rise. It would make sense to look for a fund that combines those two elements. If one decided to simply ignore the currency aspect, remember that Germany is probably the strongest country economically, while Italy offers the most value. Invest according to your own preferences or call or e-mail me for more advice.