The remarkable ‘Draghi bazooka’

The decision by Mario Draghi, president of the ECB (European Central Bank), to implement the recent long term refinancing operation (LTRO) has not only saved the European wholesale banking system from freezing up in the short term, but also paved the way for a wave of positive investor sentiment towards riskier assets in recent weeks.

The LTRO has essentially given more than 500 European banks the ability to take advantage of an unlimited three-year lending facility at a minimal cost of 1 per cent and against almost any collateral. A major credit crunch and funding crisis has been averted in one go.

The “Draghi bazooka” is aggressive, timely and remarkable – essentially quantitative easing (QE) through the back door – and a second tranche of the LTRO will be made available on February 28. However, we are also mindful of the fact that underlying debt to GDP ratios for all southern European countries remain at dangerous levels and their solvency issues have yet to be resolved.

As one might expect, equity, European sovereign debt and corporate bond markets have rallied hard on the development. The equity rally has primarily affected the basic material and financial sectors. Gold has performed well too. This has been aided by the chairman of the US Federal Reserve, who recently laid the groundwork for a third round of quantitative easing on the back of concerns about persistently high unemployment levels and an anticipated slowdown in the US.

He also took the opportunity to reassure markets that interest rates would remain at suppressed levels until the end of 2014, part of a drive to increase the transparency and predictability of policy at a time of global economic uncertainty.

China remains a worry for many investors. The economy is slowing, investment growth is weak and the infrastructure building cycle is well past its peak.

The speculative investment property bubble is in the process of being lanced and export demand from Europe has collapsed. It is difficult to get a handle on the true extent of this slowdown as data provided by the People’s Bank of China (PBOC) has some flaws.

That said, official statistics tell us that quarter on quarter growth has already slowed from 9.5 per cent in the third quarter of 2011 to 8.2 per cent in the fourth. China may ultimately avoid a hard landing but it will take time before we know for sure.

The global economy is likely to grow by circa 2-3 per cent in 2012. The good news is that inflationary pressures are subsiding. ISI Research recently published a document confirming that over 56 policy easing moves have been made across the global economy over the past four months. This easing cycle is set to continue at a time when a huge amount of liquidity is being pumped into the world economy via quantitative easing.

Equity markets are now delicately poised. On the one hand they are susceptible to disappointment. On the other hand, it is abundantly clear to us that the ECB has grasped the enormity of the eurozone banking liquidity crisis and is prepared to do whatever is necessary.