EU Monetary Policy Change: What's the Impact on Vanguard European Stock Index?

What's the outlook for Vanguard European Stock Index in the event of more aggressive monetary policy by the European central bank?

Apr 8, 2014 at 8:24AM

The European Central Bank could make an important decision soon. Pricing data in the European Union has been coming in weak, hitting the lowest level in more than four years. This adds pressure to ECB President Mario Draghi, who might start looking for ways to counter the deflationary threat in the region. What can he do? Two things: cut interest rates and/or start a round of quantitative easing to boost activity levels and push prices up. During last week's monthly meeting, the ECB left its policies unchanged, but calls for action are mounting, and Draghi says measures including asset purchases are on the table.

With the U.S. Federal Reserve winding down its quantitative-easing program and the Japanese central bank finishing its strong QE of 2013, it might be Europe's turn to try a more aggressive policy to drive its economy. After all, the austerity measures designed to curtail the unsustainable deficit spending kept demand soft in the region and did not solve its problems.

How could this impact European assets?  
Normally, a drop in interest rates and expansive monetary policies are positive for capital markets. In Japan, for example, the Nikkei grew more than 60% last year, while the U.S.' S&P 500 gained 28%.

For a closer look at how Europe is doing, consider the best-known broad European index ETF, Vanguard European Stock Index (NYSEMKT:VGK). This fund invests in large- and mid-cap stocks based in 17 developed European markets, representing most of the investable market.  Many of the fund's largest holdings are quality multinational names such as Nestle (NASDAQOTH:NSRGY), Royal Dutch Shell, Roche, and HSBC (NYSE:HSBC). But if you consider weight by country, the U.K. comes first with 33%, followed by Switzerland with 14% and France with 14%.

The good news about this ETF is that it has limited direct exposure to the weakest members of the eurozone, like Italy and Spain, which together account for less than 9% of the portfolio. And regarding its large positions in Swiss and U.K. assets, these countries have not adopted the euro, so the ECB's potential monetary-policy change would not directly affect these positions.

Following this line of thought, a position in HSBC is good for counter-balancing the exposure to Europe, as this bank enjoys the benefits of its geographic diversification. HSBC is now highly focused on growing in the emerging markets, and it reduced its retail operations in the U.S. because they were not performing as desired. Growth in Europe has been slow, especially in the U.K., but HSBC's solid foothold in fast-growing markets in Asia and Latin America should allow it to outperform its stagnating European peers.

A similar outlook applies for Nestle, which has a presence in almost every market in the world. However, the company's management has said 2014 will be challenging and in line with its sluggish 2013 performance. Last year, Nestle recorded the slowest organic growth rate in four years at 4.6%. Unfortunately, Nestle CEO Paul Bulcke does not foresee strong growth in Europe for this year. However, he is a bit more optimistic about the emerging markets, where the company has a strong position. He reckons Nestle will continue to grow in these economies, but at a slower pace. Nestle showed 8.8% organic growth in the emerging markets in the first nine months of 2013 versus a 1.1% rate in the developed markets.

Final foolish thoughts
The European economy is slowly recovering, and although avoiding deflation is important, the ECB is more focused on growth. According to the Markit Eurozone Purchasing Managers' Index, business activity across the eurozone has been expanding for nine consecutive months, so let's not get ahead of ourselves.

In addition, according to Moody's, full-blown deflation of the euro area is unlikely. The firm expects a low-inflation, low-growth scenario to persist, and it announced that there might be an increase in the debt burden for the next five years.

The Vanguard European Stock Index ETF is a good option for investors who want passive exposure to European equities. This applies especially if they believe that a recovery will gain traction.

Europe still faces significant economic risks. The roughly 11% unemployment rate across the E.U., and the headwinds created by the austerity measures are proof that many issues still need to be resolved. So if prices become an extra concern, the ECB will eventually have to do something.

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