Summary
- As was widely expected, the ECB did not disappoint on Thursday
- The euro should weaken relative to the USD in the months ahead
- If the USD strengthens, expect the consumer discretionary sector to outperform and the energy sector to weaken
Four months ago I laid out the case to expect the European Central Bank to bring out the monetary bazookas this year in response to slowing economic growth and weakening inflation (article here). The logic for such a move at the time was based on the clear link that has now developed over the last several years between the ECB's balance sheet and money supply growth, which was illustrated previously with the following graphic:
Based on the lead time between changes in M1 and the year-over-year (YOY) rate of change in the ECB’s balance sheet, we should expect the ECB’s pace of annual growth in its balance to quicken heading into the middle of 2015.
The last time the ECB significantly expanded its balance sheet (in 2011), over the next several years global stock markets took off, the euro fell, the dollar rallied, and commodities sold off.
I believe that the ECB stimulus announced Thursday (and likely more to follow) may spur global animal spirits once again. This also seems to be a more probable outcome for market-moving, hedge-fund titan David Tepper who recently told CNBC that his chief market concerns have now been “alleviated”:
Last month, the founder of Appaloosa Management said at the SkyBridge Capital's SALT conference that he was "nervous" about markets and that with Europe rates, China and U.S. growth concerns, investors should approach the market with more caution.
Those views changed. "Bottom line is, all of those things alleviated, one by one by one to a certain extent," Tepper said in a phone call to CNBC.
Major averages, which had been largely flat most of the morning, rallied following Tepper's comments, pushing the Dow and S&P to fresh record levels.
Perhaps the biggest implication of the ECB’s announced stimulus will be on the currency markets where the euro is likely to weaken relative to the USD as the ECB is set to ramp its balance sheet while the US Fed “tapers” its own. Shown below is a graphic that highlights the impact of the relative balance sheets between the ECB and the Fed on the EUR/USD exchange rate. It appears the Fed’s balance sheet is in the process of peaking relative to the ECB’s and thus a peak in the euro relative to the USD.
One of the implications we saw after the 2011 ECB announcement was the outperformance by the consumer discretionary sector. The sector benefited from lower commodity prices and lower general rates of inflation as the USD strengthened, which boosted discretionary spending. When the USD bottomed on August 17, 2011 the consumer discretionary sector outperformed the S&P 500 by 6% over the next twelve months. Should the USD strengthen going forward I would expect the sector to outperform the market given the strong link between its relative strength to the S&P 500 and inflation trends.
Shown below is the YoY percentage change in the consumer discretionary sector ETF (SPDR Consumer Discretionary Select Sector (ARCA:XLY)) relative to the S&P 500 (SPDR S&P 500 (ARCA:SPY)) shown in black with the US headline CPI YoY growth rate shown in red and inverted for directional similarity. We can see that the recent trough in inflation coincided with the recent peak in the consumer sector’s relative performance to the market. Should the USD begin to strengthen in the weeks and months ahead, I would expect the sector to begin outperforming the market again.
There is another side to the inflationary relative performance trend and that comes from the energy sector (SPDR Energy Select Sector Fund (ARCA:XLE)). The energy sector tends to outperform the market in rising inflationary environments and underperform in disinflationary environments (see below). Should the US CPI inflation rate moderate going forward on the back of a stronger USD, we may see investors rotate from the energy sector (the third best performing sector year-to-date) and into the consumer discretionary sector (the worst performing sector), which has lagged the market and may play catch up from here.
Source, all charts: Bloomberg
Summary:
The ECB brought out the monetary bazookas as expected and hinted of their plans to do more in the coming months. We are likely to see the ECB’s balance sheet expand at a faster pace than the US Fed, which implies the euro should weaken relative to the USD in the months ahead. If this occurs, we should expect US inflation trends to moderate on the back of a stronger USD, which should boost discretionary spending and cause the consumer discretionary sector to outperform the market as it did in the middle of 2011. It is quite likely that the source of funds to drive the consumer sector higher will come from the energy sector, which is this year’s third best performing sector and is also negatively correlated to inflation trends.