Friday, November 8, 2013

ECB Cuts Rates when Stock Markets are at Record Highs

The ECB took Financial markets by surprise when it announced a 0.25% cut in its core interest rate on Thursday. Most analysts, including yours truly, expected rates to remain as they were and indeed few expected rates to ever dip below the 0.50% rate announced earlier this year. It is obvious the ECB is less than impressed with the limp growth being experienced in the Eurozone, and with inflation running at a meagre 0.7%, the European economy is in danger of slipping into a Japan-like decade of economic stagnancy and deflation. Indeed we can say we are already half way along that road.

But is the ultra accommodative policy of the ECB enough to help Europe reverse course? Experience elsewhere would suggest not. Japan's lost decade occurred at a time when the Bank of Japan kept interest rates close to zero, printed money at will and facilitated a carry trade that saw the Yen kicked around in currency markets. Despite the exhaustive efforts of the Bank, apart from exporters, there was very little economic uplift in Japan's domestic economy and the country has spent the best part of twenty years in a deflationary rut.

So can Mario Draghi & Co. avoid the economic chasm that so engulfed Japan for much of the past twenty years? We are five years in and thus far the omens are not good. The ECB and the Eurozone are running out of options and unless European consumers begin to find work and find the propensity to spend, then stagnation will become denigration and to déja vu we are doomed.

Given the German influence within the ECB and its strong resistance to quantitative easing as a method of economic stimulation, the Eurozone is highly unlikely to follow the same path as Japan, the US and the UK in rolling out the printing presses, simply to appease the flawed political lines of economic argument. One thing we have learned over the past five years is that quantitative easing has had minimal positive impact on real economies across the world and it has merely acted as a tool by those at the top end of the financial tree to stoke the fire in financial markets.

Since the economic collapse five years ago, virtually the only place where we have seen inflation, and indeed heightened inflation, has been in stock markets, commodity markets and in a range of other financial instruments. Indeed many of the increases in these markets are hyper inflationary and are totally out of synch with consumer experience and with the normal rules of economic supply and demand. To be fair there are two very real contributory factors leading to the growth in major stock indices, one being that the lack of credit on the ground has squeezed out a huge chunk of the SME market in favour of cash-rich conglomerates, and the other being that sustained growth in the developing world has hugely benefited multinational PLCs.

However there remains a huge disconnect between the growth in stock markets as against GDP growth in the real economy which suggests financial markets are due a very significant correction downwards. Investors in stocks should not take the ECB move on Thursday as a positive sign for the medium-term outlook for stocks. The ECB is not the line of either first or last defence for financial markets in the same way the Fed acts as the great protector of Wall Street. And with ECB rates at a level under which there is no scope, when the trap door opens under the weight of inflated stock markets, there will be little to nothing the ECB can do, even were it as inclined as the Fed to intervene.

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