The Euro has largely been instrumental in moving asset classes all over the place over the last one year. The world is watching the Euro for cues on direction of equities, currencies and commodities. What is the outlook for the Euro and how will Euro movements affect Indian equities?
ECB is willing to print money
The ECB (European Central Bank) signalled in its policy meet on the 2nd of August 2012 that it would start purchasing bonds of Spain and Italy to prevent the collapse of the currency due to unsustainability of debt levels of these countries.
Spanish ten year bond yields had gone up to levels of 7.5% from levels of 5% in the January 2012 to July 2012 period on worries of debt levels of Spain. Spain’s debt levels at 72% of GDP is seen as being difficult to service given that the country’s economy is in recession after contracting for the first two quarters of 2012. Spain has the highest unemployment rate in the Eurozone at close to 25% and its fiscal deficit for 2011 was at 8.5% of GDP. Spain’s total public debt is over Euro 700 billion making the country a threat to the Eurozone if it defaults on its debt.
Italy has a debt of Euro two trillion with debt to GDP ratio at 114%. Italy’s ten year bond yields had risen from levels of 4.9% to levels of 6.6% in the January-July 2012 period on worries of the absolute levels of debt. Italy, unlike Spain did not have a housing bubble burst (Spain’s housing bubble burst in 2008 leading to the sharp fall in the country’s economy), but Spain’s woes rubbed off on Italy leading to a surge in its bond yields.
The ECB is trying to prevent further rise in bond yields of Spain and Italy by buying bonds of these countries. ECB bond purchases (ECB will buy short maturity bonds of Spain and Italy to reduce refinance risk) will calm bond investors and will also infuse liquidity into the system. ECB bond purchases if not sterilised is akin to printing money.
What does ECB bond purchase mean for the Euro?
The Euro has lost over 20% and over 43% against the US Dollar (USD) and Japanese Yen (Yen) respectively over the last five years. The sharp fall in the Euro is due to the debt crisis of Eurozone countries of Italy, Spain, Greece, Portugal and Ireland. The Euro is currently trading at Euro 97 levels to the Yen and Euro 1.23 levels to the USD. ECB bond purchase without sterilising liquidity will flood the system with cheap money. The ECB policy rate is at 0.75% and banks in the Eurozone will look to deploy the liquidity in higher earning asset classes. The Euro will be a funding currency of choice for the market if the system is flooded with cheap liquidity.
ECB has already pumped in over Euro one trillion through its LTRO (Long Term Refinancing Operations) in December 2011 and February 2012 where it provided banks money at 1% for three years. The Euro has declined by over 8% since the LTRO operations.
The outlook for the Euro is down on the back of ECB signalling bond purchases.
What is the outlook for asset classes on a falling Euro?
The Euro has earlier been seen as positively correlated to risk assets i.e. a strong Euro meant higher equities and commodity prices and vice versa. The correlation has held over the last one year with Euro down by 14% and equities (except US equities) and commodities returning negative. See monthly. The question is will the correlation hold or will it break?
The correlation will break with a weak Euro spurring equities though commodity prices will be muted due to a weak Chinese economy. China’s economy grew at the slowest pace in three years, growing at 7.6% in the second quarter of 2012. Outlook for China’s growth is not very bright given the issues of property bubbles, over investments and bank bad debts facing the country.
Equities on the other hand will gain on a falling Euro, as cheap Euro liquidity will lower risk premiums on equities. Cheap money will find its way into equities across the world given that corporate sector in many parts of the world have been resilient in a weakening economic scenario.
India too will benefit from a falling Euro and the Sensex and Nifty will trend higher as liquidity finds its way into the country. FII’s have already invested around USD 12 billion in Indian equities and bonds in calendar year 2012 to date and are likely to invest more going forward. The Indian Rupee, which is down over 25% against the USD over the last one year, will benefit from FII flows but given the high current account deficit (CAD at 4.2% for 2011-12 was highest on record), the Rupee is not likely to trend down highs seen in 2011.