Last week, at an investment conference in London, Mario Draghi, President of the ECB pledged to do "whatever it takes" to prevent the collapse of the eurozone. Right after the speech, the EURO rallied and Spain's 10-year bond yield retreated towards 6.5% while Italy's 10-year yield fell below 6%.
This week, Draghi secured the endorsements of Germany and Francce for a plan to reduce bond yields in Spain and Italy. Draghi's proposal to tackle the Euro crisis involves:
1. Providing long-term loans to European banks
2. Getting Europe's rescue fund, the European Financial Stability Facility (EFSF) to buy government bonds on the primary market.
3. Getting the ECB to buy government bonds on the secondary market.
However, the biggest hurdle to this proposal comes from the German Federal Bank (Bundesbank), which reiterated its opposition to the ECB's bond buying program, arguing that it blurs the line between monetary and fiscal policies. The good news is that while the Bundesbank is the central bank of the eurozone's biggest economy, it has only one vote on the ECB's 23-member governing council and could be overruled on the issue.
At the moment, the relief seems to come from the EFSF, which allows the funds to directly recapitalise banks and ultimately lowers government borrowing costs. But it is important to note that the EFSF is still a temporary fund, and investors are waiting for the establishment of the bloc's permanent rescue fund called the European Stability mechanism (ESM). The EUR500 billion ESM is on hold pending a decision by Germany's Federal Constitutional Court, set for 12th Sep 2012.
There are several implications for this:
1. The EUR currency will probably be the weakest major currency to borrow against. It has turned into a carry trade currency, a hot favourite for speculators to borrow against and change into other stronger currencies. The low interest rates in the Eurozone is another big contributing factor to the currency's weakness. Whatever the outcome, the EUR will be the big loser. A weak EUR benefits all the Eurozone members. It allows Germany to maintain its trade surplus without inflation shooting up as unemployment is still high in Germany. It allows other Eurozone members to devalue their debt without deflating. The entire circus in the welfare state of the EU will continue for years to come. If you borrow in EUR, be sure to convert to SGD and invest in bonds / equities / real estate.
2. The USD is also another weak currency that will fall further if QE3 is announced. The US is into too much debt to repay. It has to devalue its currency to remain solvent. With unemployment at 8.2%, devaluing the currency is a very attractive option. Again, it is very good to borrow in USD but be sure to swap to SGD and invest.
3. Eventually, Greece may leave the Eurozone. From my grapevine, the Greek government has not fulfilled any of the requirements to reform. When Greece eventually leaves, stock markets will shoot up.
4. Bonds are increasingly unattractive relative to stocks. The dividend yields of many stocks are increasingly higher than their bonds. Far too many investors are flocking to bonds / cash, chasing after the pitiful amount of yield. The bond market will eventually unravel once inflation sets in and interest rates start to rise. 2014 may be the D Day for bonds.
5. Emerging Markets, Asia ex Japan, Latin American and European equities may outperform US equities in the near future. The S&P500 Index is approaching the 2011 high. However, most other stock markets are still languishing. Sooner or later, investors will flock to value plays in non-US stocks. Always go for the laggard and try to avoid chasing winners.
6. More QE may not help the economies in the US and EU. UK has been doing its own QE for several years and yet it still plunged into a second recession in 3 years. It is not a silver bullet. It may push up hard asset and stock prices. But its effects will eventually wear out within 6 months.
7. QE actually delays the inevitable crash by a few more years. Already, rental yields in Singapore are at historical lows (around 2 - 3%). Properties around the world are still attractive investments despite their record low yields, because interest rates are at record low levels. Eventually when the music stops and interest rates start rising, property and bond prices could skid.
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