Macro: Sandcastle economics
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Will Draghi leave with a bang?
Peter Garnry
Chief Investment Strategist
Summary: Equities are continuing their rally with the USD weakening further as central bank meetings will set the tone for markets. Consensus is looking for a big ECB move with lower deposit rate, restart of QE and a new tiering system for excess reserves. Investors should be overweight European banks going into the ECB meeting on Thursday and be ready to take the gains as the industry's long-term outlook is still weak.
This week is all about Thursday’s ECB meeting as the US-China trade tensions have been benched until after the CCP’s 70th anniversary on October 1. Consensus is aligning on three key measures to be implemented by the ECB, 1) deposit rate cut by -10 bps or -20 bps, 2) restart of Quantitative Easing with varying estimates on the monthly amount, and 3) tiering system for excess reserves. These aggressive measures are designed to stop the decline in economic activity that has hit the manufacturing powerhouse Germany the most. But will it work and how can investors play the ECB policy decision?
European banks to see repricing
When Japan entered into negative rates in January 2016 it introduced a three-tier system on excess reserves as its negative policy rate combined with quantitative easing would significantly increase the “penalty deposit tax” for banks. When the ECB introduced negative rates, it did not implement it with a tiering system as the ECB board was afraid that it would signal negative rates for a very long period. A tiering system allows banks to move their excess reserves created by quantitative easing from the deposit rate into a refinancing facility earning 0% instead of a negative rate.
Now consensus is expecting ECB to finally introduce the tiering system alleviating the pain for core European banks which sit on the majority of the €1.9trn in excess reserves. But will it help much? Japanese banks have done worse than European banks despite the help of a tiering system, so the tiering system does not change the long-term outlook for banks. But an ECB tiering system would ease core European banks of costs around €1-7bn depending on the size of the tiering system. This on the margin should lift valuations on core European banks. Our view is that investors could play this into the ECB meeting and capture the expected gains from a repricing. But our longer-term view is still negative on European banks.
USD is key for equity rally
Over the past 10 years the USD has increased its role in the financial system to an extent where it is one of the most important factors explaining financial conditions and moves in equities. Whenever the USD strengthen it constraints macro growth and is a negative for equity returns. Weaker USD is good for growth and drastically improves financial conditions for emerging markets and equities typically is supported by a weaker USD.
We observe weaker USD as the week begins but the currency is still too strong for the global economy. Our view is that the equity rally will continue into next week’s FOMC meeting and a weaker USD increases the strength of the rally. We recommend investors to keep an eye on the USD for guidance on where this rally goes. Our two preferred equity markets are German and Japanese equities as those two are high beta to macro sentiment and central policy change. Especially Japanese equities seem to have an interesting setup and recent price action strength overnight.
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