Great Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change

One of the main topics of the year is the central banks’ balance sheet unwind, and the potential effect it can have on asset prices. As JP Morgan (and other sell-side institutions) pointed out, if we look at the annualized monthly net bond flows, the top 4 central banks (Fed, ECB, BoE and BoJ) will switch to net sellers in October 2018 (here). BNP Paribas published an interesting chart lately of the weighted average 10-year G4 bond yield overlaid with the G4 monthly bond purchases (here); we can clearly see that the increase in the total purchases has helped to push overall 10Y yields on the downside since 2010, hence eased financial conditions and stimulated the refinancing activity. However, what will happen to LT yields now that the purchases are expected to fall in 2018?

Many market participants have argued that the constant increase in central banks’ balance sheet has levitated all asset classes, and particularly the stock market; therefore, one economic area we are watching closely during the unwind is the Euro zone. If we look back three years ago, when Mario Draghi announced the launch of the 60-billion Euro bond-buying program on January 22nd, 2015, the ECB balance sheet was totaling 2.15tr Euros and the equity market EuroStoxx50 was trading at 3,400. As of today, the central bank’s assets are north 2.3tr Euro (the ECB balance sheet surpassed the Fed’s one last summer and is now worth 4.5tr Euros), while the EuroStoxx50 Index is up a mere 200pts, currently trading at 3,600 (here). We can clearly notice that the ECB effect on European equities was non-existent. It looks like the European equity market has been a dead market over the past couple of years; the Eurostoxx 50 has been trading sideways within an 800-point range between 2,900 and 3,700 and sits at its 50% Fibonacci retracement from its mid-June-2007 peak to Feb-2009 trough.

Hence, we chose this week to overlay the yearly change in the ECB balance sheet’s total assets with the yearly change in the equity market (18-month lag). As you can see, the two times series have shown some co-movements since the Great Financial Crisis; a decrease in the ECB assets is usually associated with a negative YoY performance in the EuroStoxx50 18 months later. For instance, the ECB balance sheet yearly change switched from +60% in June 2012 to -24% in January 2014 amid early LTROs reimbursement by European banks. If we look at the lagged performance of the equity market, the yearly change in the EuroStoxx50 index went from +20% in the summer of 2012 to -18% in June 2014.

In October 2017, the ECB cut its bond-buying program to 30bn Euros a month starting January 2018 for a period of 9 months, and the market expects that the central bank will taper QE to final three months of the year. With the yearly change on the ECB assets starting its downward trend, our question is the following: will the growth and investment story in the Euro area offset the expected downturn in equities?

Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change (Source: Reuters Eikon)

ECB vs Asset.png

The Fed’s 2015 dilemma: Equity market VS Oil prices

Even though the FX market is usually considered as an esoteric asset class, it happens that a lot of opportunities were in currencies last year. I mainly think about the Yen and the Euro, but the chart shows the main currency performances against the Dollar.

CurrenciesvsUSD

(Source: Hard Assets Investors)

We saw a couple of weeks ago that the economy increased at an annual rate of 5 percent according to the third estimates, the highest print since Q3 2003 when GDP rose by an outstanding 6.9.%. In addition, we saw in October that the final numbers for FY2014 federal deficit was $486bn (or 2.8% as a share of GDP), $197bn lower than the $680bn recorded in FY2013 and the lowest deficit since 2008 as you can see it on the chart below.

USDef

(Source: CBO)

On the top of that, the unemployment rate stands at a multi-year low of 5.8%, down 2.1% over the past couple of year. The only scary figures is US debt [like any other country], which now stands at a record high of 18tr+ USD, up 70% under Obama (10.6tr USD back in January 2009).

Another Good Year for equities…

I have to admit that with the Fed’s exit at the end of October, I was a bit anxious on the consequences it could have on the equity market, especially after the several ‘swings’ we saw (January, October). In my article Could we survive without QE (Part II with US yields), I added a chart (S&P 500) where you can see the impact on the equities each time the Fed stepped out of the bond market. Clearly not good.

But it didn’t. And after the 2013 thirty-percent rally, the S&P500 increased by another 11 percent in 2014 [and closed at records 53 times].

It looks to me that there are a lot of positive facts and the Fed can eventually start its tightening cycle. However, the collapse in oil prices will weigh on US policymakers’ decision in my opinion.

I think the question now is: which one will weigh more on US policymakers’ decision to tighten (or not)?

I strongly believe that the two main indicators the central bank is watching are the equity market and oil prices. An increasing equity market tends to have a positive effect on consumer spending (through the wealth effect). As a reminder, consumer spending represents 60 to 70 percent of GDP for most of the well-developed economies.

However, falling oil prices, with now Crude Oil WTI Feb15 Futures trading at $51.80 per barrel, is problematic. First of all, problematic for oil exporters’ countries (i.e. Chart of the Day: Oil Breakeven prices). We saw lately that Saudi Arabia announced that it will face a deficit of $38.6bn in FY2015, its first one since 2011 and the largest in its history (no projected oil price was included in the 2015 budget, but some analysts estimated that the Kingdom is projecting a price of $55-$60 per barrel).

I am just back from Kuwait City where I met a few investors there with a friend of mine (Business Developer in the Middle East), and most of them agreed that there were comfortable with a barrel at $60.

To me, falling oil prices reflect the weakening global demand and real economy effects. With the Chinese economy slowing down (GDP growth rate of 7.3% in Q3 is the slowest in five years), major economies back into recession (Triple-dip recession for Italy and Japan) and rising geopolitical instability, forecasts are constantly reviewed lower and problematic for debt stability [and sustainability]. I like the chart below (Source: ZeroHedge) which clearly explains that oil prices and global demand are moving together. In fact, lower growth projections combined with low oil prices and [scary] low yields are problematic for the Fed.

GlobalChart

(Source: ZeroHedge)

Moreover, falling oil prices is problematic as it will drive US [and global] inflation lower. The inflation rate is slowing in most of the developed economies: in November, UK inflation fell to a 12-year low of 1% in November, EZ policymakers are still working on how to counter rising deflation threat (prices eased to a 5-year low of 0.3%) and US CPI fell at the steepest rate in almost six years to 1.3%. Most of the countries whose central banks target inflation are below their target.

2015: New Board, new doves…

In addition, as you can see it below, the ‘hawks’ members – Fisher and Plosser – are out this year and this could change the tenor of debate within US central bank’s policy-setting committee.

FedBoard

(Source: Deutsche Bank)