Wednesday, November 6th, 2013

Waiting on the ECB

Tomorrow is the ECB meeting for November. Of late, it has been difficult to get excited in the run-up and judging from this month’s previews, most economists have the same problem today. For the record, we expect no change despite the recent cut in GDP forecasts and accumulating evidence of deflationary pressure. By contrast, there is evidence that the FOMC may keep monetary policy looser for longer, based on reports that they will cut the unemployment threshold from 7% to 6%. Research due to be published at this week’s IMF meeting will apparently explore this issue in relation to the recent decline in the participation rate. If correct, this would lead to more upward pressure on the euro, which is just about the last thing that the ECB wants.

All our asset allocation models use current exchange rates to work out the split between domestic and international equities. At present the highest weighting in the US dollar model is Eurozone equities, followed by UK equities. Part of the reason is the recent strength of the euro and sterling (or weakness of the dollar, if you prefer). If we exclude the FX effect, both exposures would be lower – exactly how much depends on how the alternative version of the model accounts for FX risk. The subject quickly becomes esoteric, so we will pass on the details and just say that the difference would be significant.

We don’t expect the ECB to cut interest rates this meeting, but if current trends continue it becomes more and more likely that they will move eventually. A 25bp cut will do nothing to boost economic growth on its own but it might help to prevent the euro from rising in Q1 2014, while we wait for the FOMC to tighten. If there is no cut and the euro continues to rise, it is hard to see cyclical sectors such as Industrials and Consumer Discretionary continue their leadership of Eurozone equities. If investors ever come to believe that the strength of the euro is choking off the recovery, it is hard to see much further progress from equities, until there has been a correction, or a change in policy, or both.

For the first time since August our US dollar model shows no week-on-week increase in the weighting of Eurozone equities, and August was the Syria crisis which interrupted the main trend, which started in June. It is too soon to recommend taking profits, but it feels as though we have come to a cross roads. If the euro appreciates further it must act as a brake on the recovery and there will be a correction led by the cyclical sectors. If the ECB looks as though it may cut rates in December, the currency play which has boosted euro equities will go into reverse.

Either way, it is time for US investors to think about what to buy when the Eurozone rally fades. We think emerging market equities are worth a look and will develop the thinking behind that call in future notes.

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