Sceptical about positive surprise from ECB: Morgan Stanley

In an effort to save the euro, the European Central Bank (ECB) is trying to resume its bond buying programme and possibly introduce another round of quantitative easing. The ECB is also scheduled to come up with its rate decision on Thursday.

Ahead of the meet, ECB president Mario Draghi has already raised hopes of embarking on a bond buying program. However, Gerard Minack, Global Cross Asset Strategist of Morgan Stanley believes although, the ECB has tools to moderate the sense of crisis in European markets, Draghi faces certain legal and political restrictions which may prevent him from being very agressive. Hence, Minack is sceptical about the ECB's ability to surprise positively.
In an interview with CNBC-TV18, Minack further added that the gap between investor expectation and the central bank's delivery will be a key risk. Meanwhile, he does not expect the Fed to move before the US Presidential elections.
Speaking about the US markets, Minack said equity outperformance in the US was due to strong earnings. However, he also cautions saying that a drop in US earnings may catch investors off guard next year. As the fiscal cliff remains the key macro issue in the United States, Minack is not very optimistic about growth and believes US growth will be lower than 2012. Here is the edited transcript of the interview on CNBC-TV18. Q: What sense did you make of Mario Draghi's recent statements and do you think the Germans will allow him to embark on his bond buying program which he seems quite intent on?
A: That is the big question. There is no doubt the ECB has the tools to use to moderate the sense of crisis in European markets. The issue is the restrictions that Mr. Draghi faces, some of them legal, some of them political and to be honest we are skeptical. We think he may have overpromised last week and end up under-delivering this week.
My colleagues in Europe do expect the ECB to cut rates at the board meeting on Thursday, but that of course I don't think will set aside markets. What we think may happen is they postpone further action until September's board meeting which I think would be an enormous disappointment to markets. That would partly be an order to buy time, get some consensus both within the ECB and amongst the broader political leadership for more dramatic action down the road.
_PAGEBREAK_ Q: In recent trading sessions there has been a sense of imminent risk-on because of his statements. Do you think the global equity markets then run the risk of a sell-off or a risk-off phase over the next 4-5 weeks on account of this disappointment?
A: Absolutely. I think this is a central bank dominated week. We are expecting both the US Federal Reserve and the ECB to disappoint expectations in markets. In US we do not expect any quantitative easing from the Federal Reserve this week. There maybe some soothing noises but we don't expect much more than jawboning.
In Europe, we are probably looking at rate cut. Perhaps some promise to reopen ECB buying or some encouragement for the EFSF to buy bonds but, I really think markets, given the price action of the last 4-5 sessions which have seen a tremendous rally in European equities in a very sharp decline in long end bond yields, particularly in Spain and Italy.
I think they are looking for the so called Bazooka option from the ECB and we are just not convinced that Mr. Draghi can deliver on the Bazooka. Therefore, yes I think we could see a serious setback to risk asset markets after that becomes clear at the end of this week. Q: Do you think eventually in the September meeting, if indeed there is disappointment this week, the Germans will come around to agreeing with Mr. Draghi or do you think it will need a precipitous market fall for all the European guys to come and singing the same tune?
A: I think the whole pattern of the last two or three years in Europe has been that it requires a crisis to get policymakers to move to the next step. We have seen a sequence of crisis over the last two or three years. They have become more adept and more unconventional in their response.
What's different this time of course is firstly, the size of the problem economies. Spain is no Greece. Spain is the fourth largest economy in the eurozone. The potential losses are far larger than what policymakers had to cope within Greece and of course it's the knock on effect to Italy which as they say is too big to bailout. That makes this a different order of magnitude crisis and therefore, the potential remedies likewise had to take a step up and become more unconventional.
The big question we are asking ourselves is have we got enough of a sense of crisis now for particularly the German policymakers to accept that. We need to go further into the unconventional policy territory. Our answer is no, we think the crisis probably needs to intensify before you get that agreement from the core of Europe that more extraordinary measures are needed.
_PAGEBREAK_ Q: By when do you think all this will happen, when the ESM moves closer to a banking license? Do you think all this is predicated as you are saying on markets movements or do you think we can work with a timeline by which all these things may fall into place in Europe?
A: I think policymakers are under tremendous time pressure and this is one of the problems that Europe has had because the legal restrictions are such that these things often cannot be implemented immediately. You mentioned the ESM, that is a great example. People are talking about a banking license for the ESM which ignores a very simple point, the ESM does not exist.
The ESM needs to be ratified by a critical number of European countries. We haven’t had that yet. We are still dealing with the hypothetical creation of this new vehicle to takeover from the EFSF. It's a classic case of the slow nature of European politics and the legislative changes needed. Whereas the market wants action and wants action now and it's that gap between what European policymakers can deliver and what the market expects that really is the risk for investors over the next few weeks and months. Q: What about the US which you just alluded to, do you think QE3 is coming if not tonight then in September maybe the Fed has more weak data points to play with?
A: We think the hurdle gets higher as the election approaches. Our view is that the Fed does not want to take a decision that could cause a political strife. Of course if things deteriorated very rapidly, I think Mr Bernanke would do QE3. But I don't think we have enough weak data yet to get the Fed to move at this week's meeting and we doubt that the Fed will move before the election.
That is quite a worry because it does seem quite clearly that the economy is losing momentum. My colleagues in the US have downgraded Q3, US GDP forecast to 1.3% and that follows on the 1.5% for the June quarter that we have just seen. But the big issue in the US in the macro sense really is this fiscal cliff, which of course is the massive tightening of fiscal policy scheduled to occur on January 1 next year.
If that tightening were to happen, we think recession is a certainty in the US. More likely, policymakers will try and delay that but, we think that is going to be quite a destabilising event in itself because we see no chance of this being resolved ahead of the Presidential election. It means there will be a very small window from the first Tuesday of November election day to December 31 to sort the mess out. I think that will be negative for sentiment and a negative for investors.
_PAGEBREAK_ Q: What is your view for 2013, whatever happens in this lurching towards some kind of euro solution and then things getting delayed; economically speaking how is 2013 looking like in the US and in Europe?
A: I think its looking very difficult, my colleagues in the US think that US growth next year would be lower than what we are seeing this year and my colleagues in Europe have just downgraded their European growth forecast. They now have a deeper recession in 2012 and no recovery, in 2013.
Now that is going to matter to investors because on the back of those numbers my colleagues are expecting, a very significant miss for forecast earnings particularly for S&P 500. The current consensus for earnings next year in the S&P is round about USD 115 per share; we are looking for EPS to be less than USD 100.
If we are right, as we head into the next year investors are going to have to face a major economic disappointment and major earnings disappointment. I think that is critical because if you are looking at the performance of equity markets over the last 12 months, the standout relative winner has been US equities.
I think the single most important reason that US equities have outperformed is this superior earnings performance of the corporate sector. It sounds like that superior earnings performance is about to come to an end and that I think will catch a lot of investors off guard. Q: You are saying that in the next 12 odd months these sporadic risk-on rallies notwithstanding, global equities might still have to work within the construct of a bearish regime?
A: Absolutely. This is the typical pattern. The aftermath of this big crisis and my own simple assumption is that we are turning Japanese. What we have seen in Japan for 20 years is several substantial rallies. Each one of them ending as growth has faltered and the bear market coming back.
For Europe and the US, indeed for the UK and Japan, these structural problems are very heavy baggage. The risks next year of growth disappointing again and for equity investors that means earnings expectations will be disappointed. The bearish trend of the secular bear market continues into next year.