The value of investments and the income they produce can fall as well as rise.
Recently the ECB, Mario Draghi, cut the benchmark interest rate to 0.05%. This is good news for the markets in the short term.
Why though has Mr Draghi cut the ECB rate when we are supposed to be in the process of economic recovery? The answer is, due to the threat of deflation and because Eurozone economic recovery was buoyed up by Quantitative Easing (QE) and not based on real wealth re-generation. Price deflation ultimately equates to negative growth or an economic contraction.
What Mr Draghi has done is to simply encourage institutional and sovereign borrowers to access this cheap financing asap while it is still available, i.e. whilst sending signals to the market that this facility might not always be available.
This ‘low rates / QE strategy’ will only work if there are other systemic structural economic reforms in the Eurozone.
For example, if sovereign states within the Eurozone encourage entrepreneurial activity by way of tax breaks, grants and support then, in time, real wealth and jobs will be created. As jobs are created more money will be spent within the Eurozone economy, this revenue is taxed and helps to re-fill the coffers of ‘the Treasury’, which can then go toward paying off some of ECBs cheap loans.
Mr Draghi is also proposing to provide funding for the Asset Backed Security (ABS) market. The fact is that, none of the bad debt which caused the credit crunch has gone away, it is still sitting on bank balance sheets but on the ‘bad bank’ side, hidden away. Finance as they say is a zero sum game.
If the ABS market is revived by the ECB buying swaths of ABS paper then the market is likely to remain buoyant for the short term, but again it will be a recovery built on a form of QE not a real recovery built on real solid financials.
In order for us to see a ‘real recovery’ the powers that be must make real structural economic reforms, analogous to various forms of QE, which will hopefully provide real wealth creation and will be the basis for a sustainable recovery, to all our benefit.
A good metaphor for a recovery based on QE, low interest rates, ECB / IMF bond buying is, the stick house built on sand. When the storm comes, the house will fall.
However, if the recovery is based on real job creation, through technological innovation, investment in domestic manufacturing and entrepreneurship then this will lay the foundations for a stronger recovery path which will more likely weather the storms ahead.
If you have money in the markets at the moment then Mario Draghi’s rate cut & proposed ABS buying spree is good news for you in the short term, although the longer term outlook for Europe is less certain.