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How we’re positioned for ECB’s growth drive

Jeffrey Sacks

By Jeffrey Sacks

Investment Strategist - Europe, the Middle East and Africa

November 2, 2017

The ECB statement of 26 October was broadly in line with what the market had been anticipating in terms of the outlook for rates. The ECB announced a further reduction in monthly asset purchases and also extended that program’s period by nine months.

The statement was slightly more dovish than expected with regard to asset purchases, particularly the open-ended commitment to adjust both size and duration further if justified. The decision to taper the former more aggressively was largely driven by the improving growth outlook. The decision to lengthen the period of asset purchases was largely driven by the inflation rate disappointingly remaining below the ECB’s 2% target.

The ECB sees the upturn as “robust and broad”, with the second quarter’s real GDP growth rate of 0.7% ahead of the 0.6% achieved in the first quarter. The ECB expects continued growth in the second half. Its easy monetary policy has been increasingly impacting the real economy by way of higher consumer and corporate borrowing. We expect that corporate earnings, which are already growing at mid-teens rates, can benefit further from this. This is the main driver of European equities.

Draghi made three further comments that have longer-term implications. Firstly, he urged European leaders to accelerate structural reform in order to reduce unemployment further and raise productivity. Secondly, he stressed the need for more growth-friendly fiscal policies to supplement the ECB’s monetary policies. Thirdly, during the question-and-answer session, he noted how all the General Council members had noted the better growth conditions, particularly for households whose real incomes are rising, highlighted by the seven million jobs created in the last four years.

Regarding the implications for financial assets, our views are broadly unchanged: The announcement does not change our bullish case for Europe ex-UK equities, which is well underpinned by valuation and technical arguments made previously, and reinforced by Draghi’s comments about growth today.

The immediate Euro reaction was negative, as the statement was considered more dovish than expected. The single currency fell 1% against the US dollar to $1.1700. Key support levels are $1.174 and then $1.1675. However, the medium-term uptrend is expected to resume with key resistance levels at $1.185 and $1.188.

European fixed income is likely to remain under pressure, particularly European sovereign bonds, whose valuations were already poor and which now face the further challenge of less ECB buying. Spanish and Italian 10-year government bond yields have moved lower by 0.08% to 1.56% and by 0.05% to 1.97% respectively. The reaction was smaller in Portuguese 10-year bonds given the evident issuer constraints being reached. Corporate bonds should be more resilient, particularly with the extended buying period. We prefer high yield, where there are better spread cushions, high coupons, and a benign default outlook given the growth backdrop that Draghi described

 

 

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