The ECB left its monetary policy unchanged with President Mario Draghi remaining committed to reaching the inflation target of close to but below 2%. Worries about the Italian banking sector are overdone.
At a meeting of the European Central Bank (ECB) on 21 January, the Governing Council did not alter any of its monetary-policy parameters. However, ECB President Mario Draghi indicated that new measures may follow at the next meeting on 10 March as “downside risks have increased again amid heightened uncertainty about emerging market economies’ growth prospects, volatility in financial and commodity markets, and geopolitical risks”.
At the media conference following the announcement, Mario Draghi made it clear that the ECB’s steps announced at the previous meeting are being underestimated by market participants. He pointed out that the additional policy measures have enlarged the current liquidity programme by 680 billion euros, which is about two-thirds the original size. Further, he explained that “there are no limits to how far we are willing to deploy our instruments within our mandate to achieve our objective of a rate of inflation which is below but close to 2 percent”. Currently, this inflation rate is at 0.2 percent in the euro zone.
Worries regarding the prospects of Italian banks seem overdone, Mario Draghi said, addressing the recent sharp drop in these company’s shares. The so-called Asset Quality Reviews of banks that the ECB conducted over the past two years had already identified possible difficulties within the sector, the ECB President said. Draghi added that “Italian banks have on average a level of provisions similar to what is prevailing in the euro area, and have also a fairly high level of guarantees and collateral”.
Given the deteriorating situation of the economy in China as well as other emerging economies, and the current troubles in the commodity sector, we think that the ECB will announce additional monetary policy actions at the next meeting in March. Due to the recent fall in oil prices, we expect a substantial downgrade of the ECB’s inflation forecast. However, we do not see very much leeway for a significant extension of the ongoing asset-purchasing programme (“quantitative easing,” QE). An additional lowering of the ECB’s deposit rate is more likely, in our opinion.
What are the consequences for financial markets?
Clearly, the twin impact of slower Chinese economic growth and collapsing commodity prices is affecting global growth prospects by putting stress on emerging markets and commodity producers. Recent US data (the regional New York Empire new orders index and the “Philly Fed” index) point to a contraction of manufacturing while recently published consumer data such as car sales and housing are mixed, foreshadowing weak US fourth-quarter GDP figures. At the same time, inflation readings remain subdued and crucially, long-term inflation expectations are drifting lower. This is a sensitive point for monetary authorities.
The factors outlined above are not new per se, but their persistence has triggered a crisis of confidence among market participants, as evidenced by a broad sell-off across equity and credit markets since the start of 2016. Our 2016 scenario “Markets face a crisis of confidence” – one we have considered least likely (15 percent) thus far – has gained in probability (see our scenario overview in the Investors’ Outlook December 2015 issue) given the recent market action.
In addition, the widening of credit spreads and the correction of equity markets is contributing to a significant tightening of financial conditions. If not dealt with, this will over time affect the real economy. This is where central banks intervene to prevent financial contagion to unduly impact economic growth prospects. ECB President Mario Draghi’s forceful “there is no limit to our action” has to be seen in that context. Likewise, we can expect the Bank of Japan and the U.S. Federal Reserve to mitigate the potential fallout of market stress.
We anticipate some relief across risky assets from deeply oversold conditions but the root causes for the recent market upheaval have not disappeared: there is too much debt and too little cash-flow to ensure healthy economic growth, and disinflationary forces remain prevalent, requiring constant care from central banks to prop up liquidity. Investors will have to come to terms with the fact that this is the new normality.
Flexibility and the ability to act in a contrarian fashion – without succumbing to panic or euphoria – will remain prerequisites to successfully navigating financial markets in 2016.
Comment by Christophe Bernard, Vontobel Chief Strategist