Use the Brakes or the Accelerator?
December 2015 is providing an interesting contrast in Central Bank monetary policies. On Thursday, the European Central Bank (ECB) continued their attempts to boost the European economy with further interest rate cuts and an expansion of bond buying stimulus to a minimum of 360 billion euros (approximately $390 billion). Meanwhile, Federal Reserve Chairwoman Janet Yellen has made it clear in multiple speeches that, barring surprising economic data before the Fed's meeting on December 15-16, US interest rates will rise, albeit slightly. The strong US jobs report on Friday makes the rise all but certain.
The two Central Banks are taking opposite strategies because they are at different points in an economic cycle. While US growth is averaging some 2% during a slow but steady recovery, the Eurozone remains stagnant with GDP slipping from 0.4% to 0.3% in the third quarter. Neither economy shows any sign of significant inflation on the horizon.
Will the economic brake of interest rate hikes or the economic accelerator of stimulus produce better results? Is each being applied in a way that is appropriate to the respective economies? Or, to extend the analogy, does neither one matter because the economy is stuck in neutral?
Markets Respond Accordingly
It's insightful to study reactions to Thursday's and Friday's news. On Thursday, investors panned the ECB's news of extended stimulus and lower rates. The Dow Jones Industrial Average dropped 252 points for the day, the S&P 500 dropped 1.4%, Germany's DAX dropped 3.6%, and the Stoxx Europe 600 dropped 2.4%. Bond yields rose across the spectrum.
By contrast, Friday's US jobs report was full of good news. November saw 211,000 new jobs, and the previous month's numbers were increased by a collective 35,000 jobs. Unemployment remained at 5%, and wages grew even though the rate slowed. As a result, the Dow, S&P, and NASDAQ all increased by around 2.1% for the day. European stocks stayed relatively flat, and bond yields fell moderately.
An interest rate cut and stimulus package in Europe caused stocks to fall, while news that makes an interest rate hike all but certain in the US caused markets to rise. That may seem backwards, but it's mostly about expectations and the size of the central bank actions in both cases.
Europe's interest rate was already negative (yes, banks are paying for the privilege of letting the Central Bank hold their money) but the ECB dropped the rate further from -0.2% to -0.3%. The intent is to encourage lending and discourage banks from hoarding cash. Investors had apparently been expecting a larger stimulus and an even lower rate cut, and thus were disappointed by what they deemed an inadequate response.
On the US side, the Friday jobs report met widespread expectations. The interest rate hike is likely to proceed, and all indications from the Fed are that the rise will be small and that fiscal policy will normalize at a gradual rate. In short, it met popular expectations. Markets dislike surprises.
The US news and responses show an economy that is slowly stabilizing and returning to normality. The European news and responses show an economy at the crossroads and heading further into uncharted territory on fiscal policy. It took the US seven years of bond-buying stimulus, near-zero interest rates, and a grab bag of growth hacks — like one-time tax rebates — to reach this point. The Europeans have been on the path of stimulus and low interest rates for less than a year, with greater cuts on interest rates and less bond-buying stimulus.
Does the Eurozone have six more years of stagnation to look forward to? Probably not, but it certainly looks lackluster for the short term. The ECB predicts European economic growth to be at 1.7% for 2016 and 1.9% for 2017. The corresponding inflation rate is predicted to be at 1.1% and 1.7% respectively, representing perhaps a bit of wishful thinking as inflation is currently around 0.1%.
At that rate of steady slow growth, it's unlikely that the stimulus will be dialed back or interest rates raised over the next few years. It's possible that ECB President Mario Draghi did not take stronger action in order to leave some space to operate if this change does not increase growth.
Difference by Necessity
There may be another reason Draghi did not take stronger action. It would have been very difficult for the ECB to get stronger action through the collective approval of the member countries, especially Germany.
The Fed has one big advantage over the ECB in setting monetary policy in that it only has one government to deal with. The ECB must deal with 19 separate nations as it attempts to promote growth. That also explains the preference for interest rate control, since buying the bonds of 19 different nations makes it difficult to apportion the stimulus (and the risk) in a meaningful way.
The bond buying is structured to be proportionate to the size of the member countries, thus the stimulus is not necessarily proportionate to need. A further complication is that the ECB will not buy bonds below the ECB interest rate and lose money, yet an increasing number of European bonds are already in negative territory and within the -0.2% to -0.3% range. tes jobs report ECB
Consider unemployment issues as well. Employment rate targets may have been vague for the Fed, but they are crystal clear compared to tying efforts to targets within the Eurozone. Unemployment in the Eurozone is slowly dropping, but is still above 10% and spread very unevenly through the member nations. Greek and Spanish unemployment rates are above 20%, yet it is unlikely that those economies will receive enough stimuli to dent their unemployment rates significantly.
In essence, the restrictions that the ECB faces are likely to make the European stimulus program even less effective than the similar US effort. Recall that it took three rounds of bond buying stimulus to get America's economy to this point. Draghi probably is not done applying the economic accelerator.
Logically, European stimulus combined with a US interest rate hike should prove beneficial to European stocks. In practice, however, that may take a long time to occur and when it does, the effect is likely to be scattershot.
Much as in the US, the European market has an immediate reaction to stimulus announcements and then settles back into a normal pattern. Short-term results can seem counterintuitive, such as the rise of the Euro immediately after the announcement. In the intermediate and longer term, the dollar is likely to stay strong as interest rates increase — especially against the Euro, as the American economy outpaces Eurozone growth.
If you want to consider European stocks or bonds, do your usual homework on the companies involved, but factor in both the distinctive psychology of their markets and rules they must play by, especially with respect to bonds. Expect more steps to be taken by the ECB before Europe fully recovers. It took the Fed multiple attempts and many years of flooring the economic accelerator to produce enough economic activity that tapping the brakes lightly looks desirable.