The economy in the Eurozone is struggling at present and has been for some time now. Consistently low inflation has significantly increased the risks of deflation in the region. In response to this the European Central Bank (ECB) has taken unprecedented action by cutting interest rate to negative levels, and then dropping them again. On top of this the ECB has introduced quantitative easing (QE) to combat the economic risks of deflation and announced in their meeting last week that they are now preparing to increase these measures.
Notwithstanding the other effects that this action is likely to have, of which there are many, we believe that that this increase in QE in Europe will have a highly bullish effect on the European equities markets. The first reason for this is that the ECB’s QE has so far been, and is very likely to continue to be, targeted towards actually stimulating growth in the economy, in a similar way to QE3 in the US, rather than broad based actions that pumped money into the system to avoid a collapse as QE1 and QE2 did. This means the ECB’s new measures are likely to stimulate growth over the long term.
There is an argument that preparing to adjust or increase their QE program to improve its effectiveness shows that the current measures that the ECB have in place have failed, and that future alterations will similarly fail. However, this would be ignoring the early days of QE3 in the US. After announcing $40 billion of purchases a month in September 2012 Ben Bernanke then announced that the Fed would more than double its purchases in December that year. Given that QE3 has been successfully concluded and that the US economy is consistently improving, we can say that an increase in the size QE by a central bank does not constitute its failure. Therefore, it is reasonable to expect that the action taken by the ECB will have a positive effect over the long term.
If the ECB’s QE does have a positive effect on the European economy, then stocks are likely to rally. The consistent strength in the US economy has provided the fuel for a rally to all-time highs in the US stock market. In fact, the action taken by the Fed in the way of QE3 caused this bull market to begin before the effects on the economy were clear.
Since the beginning of QE3 the S&P 500 has rallied steadily without a correction of more than 10%, which includes the initial months before the true impact of QE3 could be seen. Last year was one of the strongest in recent history for US equities and was largely driven by the full power QE3. In 2014 we have seen have seen the effect of QE3 reduced by tapering and replaced by the growth that it stimulated, which has led to lesser, although still strong, performance in equities.
We can also look at the effect of QE from the Bank of Japan on Japanese stocks. This should be taken with some caution as a part of this QE has involved outright supporting the stock market through the purchase of Nikkei ETFs. However, the ECB has not yet ruled out a buying European equities as part of their QE expansion, so this is an altogether possible situation.
Before the most recent round of QE in Japan was announced at the end of October, the Nikkei was trading just below 15750. Upon the announcement the index jumped over 1000 points and in the six weeks since index has climbed to 17920. This gain of more than 15% shows that it was not just QE3 that was bullish for equities, but quantitative easing elsewhere as well. Given that this is one of the options available to the ECB, the evidence in Japan further supports our argument that QE is bullish for the stock market in at least that region.
Another factor that will be bullish for European equities will be the effect of the ECB’s QE on the Euro. The increase in QE will further devalue the Euro against other currencies. This will aid exporters in the region, which will add to growth, and thus have a bullish effect on stocks. However, the markets in Europe will also be benefited by the weaker Euro as overseas investors will be able to buy shares in European companies at a discounted cost. This increase in demand will add yet more fuel to a rally in European stocks.
The QE program itself is likely to drive European stocks higher by fuelling bullish sentiment and raising confidence. Following this the actual impact of that QE, which is a healthier economy, is likely to continue to add to this upwards momentum and drive the bull market over the longer term. The weakened Euro will also fuel growth in the region while simultaneously attracting overseas investors to the market. Therefore, it is highly likely that the ECB’s targeted QE will be bullish for equities and will see them rise over the long term.
Given that this is the situation, how can we profit from it? A potentially suitable vehicle for US based investors is FEZ, an ETF that is long the EURO STOXX 50 index. Through the use of FEZ one can gain a position in US dollars on European stocks. This means that one would gain by having long exposure to rising equities in Europe without suffering any currency depreciation as the Euro weakens against the US dollar.
The currency aspect is of even more significance in the current situations. The ECB is preparing to embark on new QE that will weaken their currency as we have covered. However, in the US the Fed is moving towards an increasing interest rates, which will cause the US dollar to strengthen even more. Thus, being able to gain exposure without facing the exchange rate issues is key.
However, at this point the ECB is only preparing for new QE, it has not begun yet and the exact details are unknown. This means that there is the potential for a pullback or at least neutral trading in the near term. Additionally, there are also technical reasons as to why it is not yet the opportune moment to get long European stocks. The 50 day moving average has moved through the 200 day moving average to indicate that prices have the potential to fall in the near term. Also indicating this is the MACD, which is poised for a bearish crossover that has the potential to trigger selling.
The 3090 level was closed above on Friday. However, on the previous occasions that this occurred the index quickly fell back below the level. This means that the level has not been fully gained as support and will therefore not act as such. Below this, the next major support level is at 2900, giving the market plenty of unimpeded room to pullback if there is a correction. Adding to this, the sharp recovery from the Ebola panic has led to European stocks approaching near overbought levels and as a result there is a risk of profit taking and selling in the near term.
Accordingly, although we have a bullish outlook for European stocks and believe that the ECB’s QE will be fuel a long term bull run, we are not currently adding long positions on European stocks. Instead, we are at present considering the various strategies that would take advantage of rising equities prices in Europe and which of these holds the best risk reward dynamics. These include buying calls or trading call spreads on FEZ in a similar way to how we have traded options on SPY that take advantage of the bull market in US equities. To find out exactly when the risk reward dynamics of getting long are optimal, which strategies we employ to trade equities in Europe and our market views in general, please visit www.skoptionstrading.com.