June 15, 2018—On Thursday, June 14, the European Central Bank (ECB) made the equivalent of a bar’s ‘last call’ before it stops serving alcohol. It announced at its policy meeting that the asset purchase program known as quantitative easing (QE) would be winding down in the fourth quarter of 2018 and ending by the end of December. In doing so, the ECB is joining our Federal Reserve (Fed) in stepping away from a period of unconventional and extremely accommodative monetary policy. However, unlike the Fed, which is winding down its balance sheet and is well into a rate-hike campaign (it raised the target policy rate another 0.25% on Wednesday to a range of 1.75–2.0%; see our recent blog post), the ECB is not yet ushering the party guests out the door.
While the ECB’s announcement to end QE may have come about a month earlier than expected, this was countered by a firm commitment to hold off raising rates until at least through the summer of 2019. Calendar-based guidance is always deemed as more “dovish” than data-dependence, which resulted in the euro depreciating against the dollar in Thursday’s trading session.
We do not disagree with the ECB’s decision to postpone raising rates until well after the end of asset purchases. After all, there is a materially higher growth hurdle for the ECB to raise rates than to end QE. Despite a slowing of economic data in the first quarter, the eurozone economies do not warrant such unconventional and easy monetary policy. Confidence is elevated, businesses are expanding, and lending growth is healthy for both corporates and households (Figure 1).
Figure 1: Annual growth rates of eurozone loans (%)
As of April 30, 2018.
Source: Bloomberg, ECB.
However, the ECB has a singular focus: inflation. (This is in contrast to the Fed, which targets both full employment and stable prices.) On the inflation front, the ECB is far from claiming victory, as eurozone inflation is still running meaningfully below the ECB’s 2% target (Figure 2). As such, it makes sense that the ECB would hold off on raising interest rates.
Figure 2: Eurozone inflation, year-over-year smoothed (%)
As of May 31, 2018. Represents a 3-month moving average.
Source: Bloomberg, ECB.
The ECB is very slowly pivoting toward normalizing monetary policy, but remains well behind the Fed, particularly after committing to maintaining a negative policy rate for another full year. This supports our core narrative, as it shifts the balance of risks further toward a strengthening dollar. An expectation that the dollar will trade range-bound to slightly higher was one factor contributing to our decision to reduce our non-U.S. equity overweight and add to U.S. small cap equities. We maintain an overweight to non-U.S. equities versus our strategic benchmark, as we still expect above-average growth from emerging and non-U.S. developed economies, in addition to accommodative monetary policy from the ECB and Bank of Japan. However, weaker foreign currencies eat into a dollar-based equity investor’s total return, even if the weaker currency may help the country’s exports by making their goods cheaper for foreign buyers. Overall, we are positioning portfolios for a continuation of the global economic expansion with an overweight position to equities, and we continue to monitor the dynamics at play when it comes to central bank activity, currencies, and economic growth.
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