Why a rebound for stocks depends on Europe
The stakes couldn't be higher for Thursday's policy announcement by European Central Bank President Mario Draghi.
With Greek elections following just three days later, the pause in Europe's debt crisis depends on the launching of a large and meaningful bond-buying stimulus program -- something the ECB has teased at for three years. Failure could upend the overall market calm enjoyed globally since late 2012 as well as help push Greece further toward a decision to restore the drachma and exit the euro area.
Normally, eurozone machinations are about as exciting, and relevant, for the average U.S.-based investor as Premier League soccer (er, football) matches. As in, not very. But things are different this time.
Starting with the Dow Jones industrials' "flash crash" in 2010 and continuing to ECB chief Draghi's "whatever it takes" speech in 2012, the risk of a eurozone breakup kept U.S. markets on edge. I vividly remember the day the Dow dropped nearly 1,000 points during the flash crash: Financial news channels carried side-by-side footage of the price carnage along with violent protests in Athens.
Draghi's confidence-inspiring 2012 speech -- in which he claimed that the ECB would make en masse purchases of Italian and Spanish bonds (despite a lack of clarity on whether this was even legal under the ECB's mandate) -- put an end to all that.
The euro rebounded strongly as capital flowed into eurozone bonds, pushing down borrowing costs. Last year, investors even gobbled up a new bond issue by Greece, despite the fresh memories of that country's recent private-sector bond default. Here at home, aided by the launch of the Federal Reserve's "QE3" bond-buying program in September 2012, stocks have enjoyed an unbroken uptrend that's now entering its fourth year.
But what the ECB called "outright monetary transactions" (or OMT, and a sort of precursor to QE) was only to be used in an emergency.
Although the threat of OMT stabilized the European bond market, it wasn't enough to kick-start an economic recovery in Europe because the eurozone's structural problems were never addressed. Greece remains plagued by unemployment, running at near 26 percent as of October. Italy's debt-to-GDP ratio continues to swell. Deflation (or falling prices) is spreading, risking a nightmare debt-deflation downward spiral.
So, Draghi has recently talked up a Fed-style QE bond-buying program in an effort to restore confidence while postponing an actual announcement because of resistance by the eurozone's creditor countries (Germany, Finland and the Netherlands) and the move's uncertain legality. The ECB also tried half-measures, such as loans to banks and purchases of asset-backed bonds.
Now, with deflationary forces building and economic activity stalling, Draghi has been called. He can't play for time. He can't bluff anymore. Markets demand to see the cards he's holding.
Success will spend on two factors: How large the QE program is and how much risk-sharing it involves.
The worst-case scenario would be if the ECB announces nothing at all. The middling option would be a program of around 600 billion euros with purchases largely made by central banks of individual countries, which is what Michel Martinez at Societe Generale expects. The upside scenario for markets (albeit, unlikely) would be a larger, possibly open-ended program that put the eurozone's creditor nations on the hook for any defaults by the likes of Greece, Italy and Spain.
The decision, based on leaks in the European press, seems to be coming right down to the wire as Draghi scrambles to secure political backing for action. Still, central banks have rarely disappointed markets in this business cycle and are unlikely to start now. I expect Draghi to deliver enough, at least initially, to please markets.
Over the medium term, the ongoing lack of structural reforms in the eurozone has investors doubtful this Euro-QE will solve the deflation/slowdown problem. According to RBS' Alberto Gallo, more than 50 percent of investors he surveyed believe the program will boost only the financial markets, while only four percent believe it will boost growth and inflation.
And even if the ECB delivers what investors want, it remains an open question whether it will be enough to placate Greek voters who, after years of crushing unemployment and budget austerity, are wondering whether ditching the euro is the better option.
For investors, a rebound from the stock market weakness and volatility we've seen in 2015 so far depends on both a positive reaction to the ECB's announcement as well as a positive reaction to the Greek election results early next week.
The high hurdles for success explain why safe havens, such as U.S. Treasury bonds and precious metals, have been on a tear lately.
