The ECB Has Spoken: Now What?

by Charles Sizemore | September 8, 2012 7:00 am

The “Big Bazooka” has been fired — or at least that’s how the market saw it on Thursday. Virtually all world markets were sharply higher after ECB President Mario Draghi shed more light on his plans to stabilize Spain, Italy and the other periphery countries.

He said that the ECB will engage in potentially unlimited “outright monetary transactions,” adding that “we want this to be perceived as a fully effective backstop that removes tail risk from the euro area.”

And to really drill the point home, Draghi reaffirmed that the euro is “irreversible.”

Draghi’s rhetorical gun slinging is a major boost to market bulls and a major coup over Jens Weidmann and the German Bundesbank. (See “The Five Most Important People in the Eurozone Crisis[1]” for a rundown of Weidmann and the other major players involved).

Germany Bundesbank has consistently resisted bond-buying by the ECB, arguing that it amounts to an illegal funding of states’ budgets by the ECB. They have been overruled, much to the relief of investors, though Draghi offered them an olive branch of sorts in his requirement that any state receiving ECB assistance submit to fiscal austerity conditions.

All of this sounds good, but what happens next?

Spain and Italy are being coy as to their intentions. It is a foregone conclusion that both will be asking the ECB for aid — or at least that’s how the market, like I said, is taking it. But Spanish prime minster Mariano Rajoy and Italian prime minister Mario Monti have given no indication that they plan on asking any time soon. When asked about it after Draghi’s press conference about Spain’s intentions, a seemingly-annoyed Rajoy replied, “When I have anything new to tell you, I will.”

Rajoy is playing hardball in hopes of getting more lenient “conditions.” One can hardly blame him, but it would be best if he made a decision sooner rather than later. The longer this drags out, the more likely it is that investors lose patience and we go back to 7% yields on the Spanish 10-year.

In the meantime, it would appear that Draghi’s comments have awakened the “animal spirits” dormant for most of this year. The market looks to be shifting into “risk on” mode, which means that virtually all risky assets are due for a rally. And once this gets underway, the riskier the better.

The markets most likely to outperform are those that have been beaten down the hardest, such as Spain. A 50% rise in the iShares MSCI Spain ETF (NYSE:EWP[2]) is not unthinkable.

I would also expect emerging markets to enjoy a rally and would recommend the iShares MSCI Emerging Markets ETF (NYSE:EEM[3]).  Country-specific ETFs for Turkey — iShares MSCI Turkey ETF (NYSE:TUR[4]) — and China — iShares FTSE/Xinhua China 25 ETF (NYSE:FXI[5]) — are also attractive, though FXI will likely be a wild ride.

Emerging markets have been beaten down due primarily to spillover effects from the eurozone crisis. Fewer exports to Europe by, say, China means less demand for raw materials from, say, Brazil.

I’m simplifying, of course; the major emerging market countries have plenty of domestic issues as well that do not involve Europe. And in any event, the Draghi move will not return Europe to robust growth anytime soon.

But in the short term, all that matters is perception. And right now, the perception is that the worst is behind us in the eurozone crisis. It’s time for “risk on.”

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”[6]

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