It was wonderful to visit the London office of BlackRock iShares. I want to express sincere appreciation to Doug Frey for facilitating the meeting with Karim Chedid in London. BlackRock has tremendous reach, and we have worked closely with Doug on a variety of issues. It was fascinating to spend time talking with Karim—he was very articulate and insightful. Karim is from Beruit, Lebanon, and he has worked in London for several years.
Although our meeting was in London, it was impossible not to start our discussion with Quantitative Easing (QE) from the European Central Bank (ECB) and with the current Greek crisis. The ECB launched QE in March given the low inflation and sluggish economic environment in the Eurozone. The Eurozone is in a different place than the U.S., as Europe has seen very little recovery. (While the U.S. has experience a greater recovery than Europe, the U.S. recovery is still sluggish). The ECB needed to alter the market mindset and break any risk of deflation.
One of the real questions is why it took so long for the ECB to launch QE. It was not a lack of recognition of the economic need, but the delay was a result of Eurozone political forces. While the Eurozone has monetary union, it does not have fiscal union. This raises controversy about how to divide up the purchases of bonds that is part of QE. Differing fiscal union creates a moral hazard. Countries may not implement fiscal reforms, recognizing that the ECB will buy the debt. This is obviously a long-term risk for Europe. While closer fiscal union is necessary to advance the concept of “Europe,” the opposite seems to be taking hold with the rise of nationalistic parties across Europe.
The public in the UK are glad that they are not part of the Eurozone. The Bank of England has been able to maintain its independence, and it embarked on QE in 2009. The U.K. recovery has been more in line with the U.S.
The U.K. will face key political risks in the next couple of years. Prime Minister Cameron has agreed to put forward a citizen referendum on whether the U.K. should remain in the European Union (EU). There certainly is risk of an exit, but the outcome of the referendum would likely be to remain in the EU. U.K. membership in the EU is viewed positively by financial markets, and it would be very negative for the economy and for the financial services industry the U.K. were to exit the EU. The status quo is preferred—maintaining an independent monetary policy while remaining in the EU.
The bigger political risk may surround another independence referendum in Scotland. The Scottish National Party has significant representation in the U.K. Parliament. Scotland wants more devolution, and failure to receive concession may lead to another Scottish referendum. Scottish independence would negatively impact the financial services industry, and would be a source of significant volatility.
Despite the perception that both growth and inflation in Europe are recovering, Karim saw little possibility the ECB will end QE early. The ECB will be sensitive to continued volatility in the bond market, as excess volatility can derail progress and create uncertainty. One of the main drivers in financial markets continues to be central bank divergence, and the Euro is likely to weaken further. Focus will soon shift back to a Fed “lift off,” and this will add to the structural forces that are strengthening the U.S. Dollar.
The discussion with Karim highlighted the power of central banks to move markets, the structural challenges that face Europe, and the political risks that may overwhelm economic risks.
Special thanks to Brennan Staheli, Daniel Doxey, and the Lunt Capital team for their contributions to this report.