The relationship between market participants and the President of the European Central Bank has been a turbulent one in recent times. Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council in early December, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.
Mr Mario Draghi has long struggled to convince the inflation averse Bundesbank for the need for more aggressive monetary stimulus. The unnecessarily wordy and absurdly low inflation target of a 2% ceiling adopted by the ECB reflects the influence of the Bundesbank. The widely documented upward bias of consumer price indexes globally, thanks to the rapid improvement in the quality of e-services suggests that a 2% measured inflation rate equates to a modest deflation.
The poor market response to the ECB’s decision in early December and an assist from the recent slide in oil prices appears to have given Mr Draghi the upper hand against the inflation hawks internally. At the latest ECB press conference on January 21st, Mr Draghi flagged that the ECB would need to re-assess its monetary policy stance at the next meeting in early March because euro area inflation dynamics continue to be weaker than expected. The ECB now expects the path of annual HICP inflation in 2016 to be significantly lower compared with the outlook in early December.
To boost the ECB’s credibility in terms of its ability and willingness to achieve its inflation target, the central bank will likely need to announce an expansion and extension of its asset purchase programme at its next meeting.
Decisive action necessary to rid Japan of its deflationary mindset
The Bank of Japan is similarly facing a battle to combat persistent disinflationary headwinds. At the time of writing this post, Reuters has reported comments from the BOJ Governor at the World Economic Forum that indicators of inflation expectations have been somewhat weak and that the central bank would not hesitate to adjust policy settings again to achieve its 2% inflation target. At present, consumer prices in Japan excluding fresh food and energy are only 1.2% higher than a year ago.
These comments echo those made in a speech by the BOJ Governor on January 12th, in which Mr Kuroda acknowledged that the central bank’s efforts to achieve its price stability target of 2% are only halfway there, and that decisive action is necessary to eradicate Japan’s fifteen year long deflationary mindset.
Since the launch of Abenomics in 2012, analysts have lifted their expectations of profitability for the Topix companies by 75%. In contrast, forecasts of profitability for the Euro Stoxx 600 companies have remained stagnant for the past five years (see chart). Along with the disinflationary headwinds buffeting the euro area, this represents another clear signal that Mr Draghi has more work to do.
Tactical overweight in global equities
In the past month, investors have clearly been unnerved by renewed concerns around persistent disinflationary headwinds in the euro area and Japan, China's growth prospects, and the FOMC members' projections pointing to at least another three hikes to the federal funds rate over the course of 2016. It is difficult to reconcile these projections with communications from various Fed officials that the process of monetary policy normalisation will be gradual. The Fed Governors are likely drawing some comfort from the continued firming of labour market conditions, but at the same time various indicators of US manufacturing activity are contracting.
Despite the weakness in global stock-markets in the past month, earnings multiples for the S&P500, Euro Stoxx and ASX200 remain above their ten year medians. Nonetheless, with Messrs Draghi and Kuroda signalling that more stimulus is on the way, and increased likelihood that the FOMC participants will have little choice but to downgrade their projections for the federal funds rate as the IP cycle in the United States tips over, Evidente recommends investors have a tactical overweight bet in global equities.