How to Know if Draghi Will Succeed at Reflation
Watch for a continuation of strength in Spain relative to Germany and a continued drop in the euro.
Markets worldwide are still digesting the European Central Bank's latest decision to push negative interest rates on excess reserves, with the euro beginning to weaken in a more meaningful way. It can be argued that the end goal of Mario Draghi is to depreciate the euro given that one of the best ways for Europe to get out of its deflationary funk may be to simply export more. A weaker currency allows for a country to import inflation, exporting deflation to other countries. A depreciating currency would most benefit those with the highest debt, as imported inflation helps with liability burdens. It is for this reason that during the onset of reflation expectations, junk debt and highly leveraged stocks tend to outperform.
From a macro perspective, while Germany would benefit from a depreciating euro given how strong its export economy is, Spain would likely benefit more. With extremely high unemployment and a tremendous debt burden, inflation would most impact equities in the PIIGS more generally. Take a look below at the price ratio of the iShares Spain ETF (NYSEARCA:EWP) relative to the iShares Germany ETF (NYSEARCA:EWG). As a reminder, a rising price ratio means the numerator/EWP is outperforming (up more/down less) the denominator/EWG. Note that as expectations grew in the first part of 2014 that the ECB would further stimulate, Spain outperformed relative to Germany.
The trend remains intact, which is consistent with the market giving the benefit of the doubt to Draghi and inflation expectations rising. A continuation of the euro's drop would confirm this. I don't believe that negative rates will necessarily increase lending and the velocity of money organically, since banks can simply pass down negative rates to their own depositors in the form of various increased bank fees. As I argued on CNBC recently, negative rates are like bringing a butter knife to a machine gun fight if the goal is to increase lending. However, to the extent that negative rates end up pushing the euro lower, which the history of negative rates seems to suggest is plausible, then Europe may indeed reflate.
Bottom line? To see if Draghi will ultimately be successful, watch for a continuation of strength in Spain relative to Germany and a continued drop in the euro. The only way for Europe to reverse deflation is to export it.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter