by Shawn Narancich, CFA
Vice President of Research
The Draghi Put
September kicked off with a bang as U.S. stocks moved to four-and-a-half year highs on the S&P 500 and highs on the tech-heavy NASDAQ not seen since before the tech bubble burst in 2000. Entering what has historically been the weakest month of the year for stocks following a double-digit summer rally that few foresaw, stock investors could be forgiven for not expecting the handsome gains that we got this week. So what was behind the euphoria? In a word, Draghi. The ECB president backed up his tough talk of defending the euro by detailing a plan to “purchase unlimited quantities” of short-term European debt to preserve what it sees as the proper transmission of monetary policy. The catch? Countries must first apply to the European Union’s bailout fund and agree to prescribed fiscal reforms designed to reduce budget deficits and put troubled countries back on a sustainable fiscal path.
Another Acronym
In Europe, the Outright Monetary Transactions (OMT) plan prescribes that the International Monetary Fund be used to help oversee country specific reforms while also eliminating the ECB’s preferred creditor status in the event that purchased bonds default. If countries fail to abide by the bailout conditions, then the ECB could immediately cease bond purchases that would otherwise help nations like Spain and Italy refinance their burgeoning debts at acceptable interest rates. Bottom line, the ECB took an important step this week in preventing a disorderly break-up of the euro, but plenty of challenges remain for a region troubled by one monetary policy and 17 different fiscal regimes.
Bundesbank Indigestion
The European saga continues next week when the German parliament convenes to decide whether to sanction the Eurozone’s new bailout fund known as the European Stability Mechanism (ESM). At present, Germany’s central bank remains opposed to the ECB’s purchase of sovereign debt despite the ECB’s stated intention to inoculate bond purchases to keep the money supply stable; it claims such actions are tantamount to financing affected countries’ budget deficits. Nevertheless, Prime Minister Merkel has expressed support for the ECB’s plan and appears to have the political capital necessary to strong-arm lawmakers into supporting the ESM. If she fails, countries seeking a bailout would lack the mechanism by which they would apply for aid. For this week at least, investors were heartened by the ECB’s OMT plan, bidding Italian and Spanish debt substantially higher while reducing their accompanying bond yields. The question now becomes whether or not Spain and Italy will fumble away the goodwill the ECB has earned for them by not following through with a formal request for aid. Draghi has done his job, now the ball moves to Spain and Italy’s court.
A New Normal?
Meanwhile, investors didn’t have to look far for the reason behind why central banks globally have become so accommodative. Key economic reports were poor almost across the board, from continuing manufacturing declines reported in Europe, China, and the U.S. to yet another anemic jobs report domestically. Our economy generated less than 100,000 net new jobs last month, a level far below what is necessary to sustainably lower the unemployment rate. That rate actually declined to 8.1percent in August, but the underlying cause was shrinkage in the labor force from disaffected job hunters throwing in the towel on their job search. Economic weakness was confirmed anecdotally by bellwether Federal Express and technology leader Intel, both of which pre-announced weaker than expected earnings for the quarter. These reports lend further support for the Fed to announce a new round of quantitative easing at next week’s FOMC meeting. And let’s not forget China, where stocks rallied by nearly 4 percent today on news of substantial new government supported infrastructure investment.
Our Takeaways from the Week
- Central banks and governments worldwide are pressing on the stimulus pedal to counteract what has become a disappointingly weak expansion.
- Stocks are responding to expansionary monetary and fiscal policy by setting multi-year highs