Drugged By Draghi
Stock markets took off in the middle of last week as Mario Draghi promised to save the Euro:
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. To the extent that the size of the sovereign premia (borrowing costs) hamper the functioning of the monetary policy transmission channels, they come within our mandate.
To translate from central bankerspeak, what that portion in bold really means is that Mr. Draghi and the ECB will be buying Spanish and Italian bonds soon. Or at least that’s what bond traders the world over heard and acted on, driving down bond yields across the periphery. Of course, if traders buy the bonds in anticipation of ECB buying, maybe the ECB won’t have to buy any bonds at all but if the ECB doesn’t announce something definitive and credible at its meeting next week, then the traders will sell their bonds and force the ECB’s hand. It’s all a kind of game theory, prisoners dilemma version of monetary policy.
I’m not sure why anyone would be surprised by Mr. Draghi’s comments. He is promising to act in a way that will preserve his and his organization’s power. After all, if the ECB doesn’t print up enough Euros to buy Spanish and Italian bonds, the chances of the Euro surviving are just about zero, in which case there would be little need for a European Central Bank or a certain Italian gentleman to chair their periodic meetings and hold press conferences.
What I find at least as interesting as the market reaction is the parts of Mr. Draghi’s talk that didn’t make the headlines. Here’s the opening of his speech:
I asked myself what sort of message I want to give to you; I wouldn’t use the word “sell”, but actually I think the best thing I could do, is to give you a candid assessment of how we view the euro situation from Frankfurt.
And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.
I’ve been following central banking and monetary policy for decades and I have no idea what the hell any of that means. Who are these people who once compared the Euro to a bumblebee? Are bumblebees not real bees until they attend bee school? I suspect that if Mr. Draghi’s speech had ended there, they’d be fitting him for a really long sleeved garment right about now and markets would be a great deal lower. This is just nonsense. I don’t know what message he intended to send with this paragraph but the one I received was: Hi! My name is Mario and my meds haven’t kicked in yet! The only important message comes later in the speech:
When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro.
So keeping the Euro together is a political urgency, not an economic one. No kidding. Again, I’m not sure why anyone would be surprised at this fact. I’m certainly not. In last week’s commentary, I said:
I tend to think the Euro will stay together for now if for no other reason than there has been so much political capital – and real capital for that matter – invested in the project that the politicians will do almost anything to keep it together.
Draghi’s bet is a simple one. If he removes the threat of breakup, it reduces the urgency of the capital flight out of the southern half of the Eurozone. If Spaniards don’t have to worry that they’ll wake up one day and discover their accounts are now denominated in New Pesetas, they have no reason to send their deposits to German or Swiss banks. Draghi is a politician and he acted just as one should expect. He will preserve his beloved European Union no matter the cost and legal niceties. Investing in markets these days is at least as much about understanding the politics as it is the economics.
The fact that stocks on both sides of the pond rose on this thin reed is confirmation merely of the low expectations of market participants. US stocks have for months been trading in fear of a full blown Euro break up and the chaos that might cause. If the ECB and other European politicians can be believed – and I’m loathe to trust any of them – then that outcome has been removed from the market equation. How much that actually helps the economies in the US and Europe is questionable at best but at least the worst case scenario seems to have been taken off the table. Stocks’ move last week was just an acknowledgement that a disastrous European outcome is less likely.
The move in stocks certainly wasn’t about any improvement in the performance of the US economy or corporate America. The GDP report confirmed what we already knew – US growth is fairly anemic but we aren’t in recession yet. Earnings season has been pretty average from an expectations point of view. With over half the S&P 500 companies having reported, earnings growth is running 5.4% with revenue down 0.6%. To be fair, much of the revenue drop is at energy companies that faced lower oil and gas prices in the quarter; take them out and revenue is up 3.5%. Taking a broader view and looking at all earnings reports, 60.6% of companies have beaten earnings estimates which is in line with what we’ve seen since 2011. On the revenue side, 47.9% of companies have beaten estimates, way down from the 60% average since 2011. Only about half of the universe has reported yet so we’ll have to wait and see if those revenue numbers improve but for now it is confirming the slowdown we already knew was happening.
Of course, the other reason stocks have been rising – or at least this is what I keep hearing – is the expectation of more action from our own political central banker, Ben Bernanke. I’m not sure why stocks would rise on that expectation since all it has accomplished in the past is to raise the price of oil, but I think we’ll find out next week whether that is the true reason for the recent rally. I don’t expect any action from the Fed meeting and if stocks have really been anticipating QE3 then we should see a sell off if Bernanke fails to deliver. Of course, I could be wrong. Bernanke might announce that it is within the mandate of the Fed to preserve the US Dollar and that the spread between Treasuries and California municipal bonds is hampering the monetary transmission channel. It wouldn’t be any crazier than the bumblebee theorem.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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