The funds to buy to benefit from eurozone QE

More than 6 years on from the financial crisis a number of central banks around the world attempted to steady the ship by printing money, or quantitative easing (QE) to give it its correct title. While the mechanism of how the process works in each case may differ, to all intents and purposes it's printing money. While the likes of the US, Japan and even the UK have tried QE the European Central Bank hasn't and almost certainly looks likely to in the coming weeks.

Investors will know that QE has driven equity markets to new highs over the last 5 years and a lot of them have made a lot of money. So if the ECB is about to fire up the printing presses can DIY investors benefit and what should they buy?

What happens when central banks print money?

First let me quickly explain what happens when central banks print money (QE). The best way I find to explain QE is to use an analogy. Imagine that the UK economy is a garden full of plants which is starting to struggle and dry up in a drought. The gardner (the central bank) tending the garden has tried collecting rain water to water the garden but this has not helped and the reserves have gone. Think of that as a lose comparison with a central bank (in our example the Bank of England) trying to boost growth by lowering interest rates. So the gardner has to do something else and unnatural to try and bring the garden (the economy) back to life.

So the gardner decides to get a hose pipe with a sprinkler attached and water the garden artificially. Watering the garden is equivalent to QE and the hose pipe is the system by which the water (QE) is transmitted, which in the economy largely equates to the banking system.

But there is one snag, the hose pipe has a kink which he can't undo. So he turns the tap on and water dribbles out of the sprinkler onto the plants. So he turns it on faster and faster to make the dribble much stronger so he can water the plants to boost growth. Meanwhile, in the hose pipe the water behind the kink is building and building. And the hose pipe is expanding rapidly!

While the gardner might be pleased that he seems to averted a disastrous drought he has a few problems he hasn't bargained for.

1. When he turns the tap off there is now so much water in the pipe that once the kink clears (and he doesn't know when) he's likely to flood the garden completely and kill everything
2. He doesn't have a lot of control of where the water from the sprinkler is ending up
3. It might start raining again anyway (an external factor he's not bargaining for)

So in real life when central banks print money they do this by buying assets off banks in return for cash they've created out of thin air. The banks then have cash and are supposed to then lend it to people and businesses to boost growth. That would be the equivalent of a hose pipe with no kink. Yet there is always a kink because banks often keep the money to themselves to stabilise their own businesses. So this wall of money (water) builds and at some point they might release it and if they do it could flood the economy causing rampant inflation (i.e. flood the garden).

So what we've seen from other QE experiments is the water (money) doesn't necessarily end up where you want it. Pour a load of water on hardened ground and it doesn't seep in straight away but flows to where it wants to naturally, like a river. Where it ends up is where things will grow first, weeds and all! So this analogy helps explain the following charts.....

What happened when other central banks tried QE

They say a picture paints a thousand words.....

Here's what happened to US equities after each bout of QE:

Here's what happened in Japan when they first announced QE in late 2012

Once central banks have cut interest rates to almost zero (or even below) that's where QE comes in. The central banks usually by government bonds as they are liquid and in theory it should be easier to reverse the process in the future than buying other kinds of assets. This drives down long term interest rates in the economy (as the price of the bonds go up so yields go down) which makes long term saving unattractive. It also reduces loan and mortgage rates. This 'wealth effect' causes people to buy assets such as equities and property which explains the charts above. So going back to our analogy, the water flows into pools. And it tends to be riskier assets at that, which explains why the equity markets have rallied over the last 5 years.

Will the ECB launch QE & if so when

The ECB have been late to the QE party, largely down to protests from some eurozone members, led by Germany. The eurozone is a marriage between 19 countries where monetary policies are set by one central bank, the ECB. Inevitably what is good for one country will be detrimental to another. Yet the prospect of continued deflation (falling prices) had boosted the pro-QE camp's cause. Falling prices encourage people to hold onto their money instead of buying things, which is bad for economic growth. Printing money might just help reverse that trend as in theory it should cause inflation (prices rise as more money exists which is chasing the same number of assets that existed previously). But the legal challenges against QE were dealt a blow when the ECB's idea for QE was given the backing by the advocate general of the European Court of Justice.

Also, the Swiss Central Bank had for the past 3 years been holding down the value of its currency to no more than SF1.20 to the Euro by buying euros and selling its own currency. But yesterday it gave up on this and the Swiss Franc strengthened by nearly 40% at one point in the day! That's unprecedented for a major currency and is seen as another sign that the eurozone QE (money printing) is coming and the value of the Euro will fall. The Swiss Central Bank just does not have the firepower to fight it.

So the markets are pricing in eurozone QE to be announced as early as next week.

How to play eurozone QE

While the assets the ECB decides to buy to deliver QE should rally (most likely government bonds), playing that trade can be difficult until we know further details. For example, which sovereign bonds will they buy? But at least in theory some European bond funds may benefit.

However, based on history and other QE programmes european equities could well receive a boost. The fly in the ointment is that markets have already priced in the anticipation of QE commencing soon so equities might not rally much upon announcement. A lot rides on the scale of the QE if announced. If it's small in size the market will be disappointed and shares will fall. If it is bigger than expected (a bazooka) then things could get exciting.

First of all QE is about lowering the euro. So if you are brave and want to play the currency angle then have a look at a cheap ETF such as ETFS Short EUR Long USD. The monetary policy in the US is going the opposite way to in Europe so the dollar looks set to strengthen against the euro further. For more on the how to play the dollar strength click here.

As highlighted by the earlier gardening analogy one sector likely to benefit is the banking sector. Elsewhere exporters will benefit from a weaker euro while mid-sized and smaller companies are likely to get a boost from increased liquidity and an uptick in mergers and acquisitions, as the cost of funding falls.  A bold play would be to buy Baring Europe Select which has a small cap focus, with financials as its biggest sector by exposure (19%) . The fund remains one of the top performing European funds over the last 3 and 5 years.

Another way to play it is chose a fund which is sensitive to the wider market (this can be statistically measured by something called beta) but where the manager does add value (measured by alpha). In this instance you might pick Artemis European Growth.

Finally you could buy the european stock market while hedging out exposure to the falling euro. That way what you make on the shares you don't lose on the currency conversion. One cheap way to do this is via an ETF such as UBS - ETF - MSCI EMU 100 % hedged to GBP.

One word of warning, there are still some serious downside risks out there for European equities. The potential for a Greek exit from the eurozone following this month's elections being one of them.

 

 

(Photo by David Castillo Dominici - freedigitalphotos.net)

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