Lower Rates and More Liquidity Make Europe a Buy

The ECB announced strong new monetary policies that should affect financial institutions in the European Union. How will iShares MSCI EMU, Vanguard FTSE Europe, and iShares MSCI Europe Financial perform?

Jun 13, 2014 at 2:27PM
European

Source: Eric Chan/Flickr

Europe is facing an unprecedented round of monetary measures that could mean major price changes across the region. The European Central Bank recently lowered its benchmark interest rate 10 basis points to a record low of 0.15%. Now the region's rate is below its U.S. and U.K. equivalents, which are currently at 0.25% and 0.5%, respectively.

In addition, deposit rates with the ECB will be -0.1%. Yes, you read that right: European banks face a negative rate on their excess funds if they keep them overnight with the central bank. This is the first time we've seen a major central bank taking its deposit rate negative. Now banks will have a stronger incentive to give a profitable purpose for this cash, which means they will essentially invest it and lend it, boosting activity levels and pushing European asset prices up.

But wait, there's more. In order to reinforce bank lending, the ECB also announced a new asset-purchase plan and the opening of a $542 billion liquidity channel destined for this purpose. With  money being poured into the economy, and deflation risks mitigated, it might be time to start a position in the region. Let's check out some Europe-related ETFs.

Euroimage

Source: Pixabay.

What Europe-related ETFs could you buy?
If you prefer equities, an interesting ETF to follow is iShares MSCI EMU (NYSEMKT:EZU). This fund tracks the performance of the equity markets of the EU members that have adopted the euro as their currency. This is exactly what you should be looking for, as similar ETFs like Vanguard FTSE Europe (NYSEMKT:VGK) have among their biggest holdings companies denominated in pounds and Swiss francs. Of course, these companies have operations in the whole region, but the monetary policy does not have a direct impact on their businesses.

Regarding iShares MSCI EMU, its holdings are pretty well-diversified across sectors, with relatively large weightings in financial services (21.2%), consumer cyclical (12.3%), and industrials (12.1%). This is good news, as greater lending incentives and liquidity measures should increase financial-services activity and spur industrial activity in the region through credit.

In addition, staving off deflation should boost consumer confidence. Decreasing prices make people push purchases forward and wait for prices to drop, and that's exactly what we don't want. Retail activity in the region is gaining traction already: June retail sales for the eurozone rose 0.4% from May and 2.4% year over year, their strongest annual growth in seven years.

However, if you think the measures' major impact will be within financial institutions, the fund you should consider is iShares MSCI Europe Financials (NASDAQ:EUFN). New monetary policy has a direct effect on banks. Sooner or later other sectors will feel the effects, but the extra liquidity and higher lending will take place through banks. This fund tracks financial companies across Europe, with more than half of holdings being eurozone-based.

Why now?
The market's initial reaction to the policies' announcement has been a clear buy. Most European shares closed higher as investors considered that the ECB's intentions should boost the economy in the region. In addition, the announcement led to a drop in the yield, and consequently a rise in their prices, of most European sovereign bonds. This was especially evident in the bonds issued by Spain, Italy, and Ireland.

The purpose of these measures is to stop deflation threats in the region and boost lending. This year's ECB inflation projections were lowered from 1% to 0.7%, a step in the wrong direction.

Final foolish thoughts
The EU is the world's second-largest economy, and these strong measures should be closely monitored. The region has not managed to recover as fast as previously expected, and higher bank lending could make a difference.

From now on, Europe will be facing liquidity expansion with extremely low rates and this should be beneficial for equities in the region. It is hard to imagine a scenario where the additional cash leads to inflation without boosting economic activity. The rise in sales in the eurozone is not a minor thing either and should gain more traction after the new measures take place. Under this scenario, iShares MSCI EMU is a good choice since it holds its biggest positions in the sectors that will profit the most from the policies. If you still want exposure to the region, but do now know how effective the ECB will be in turning things around, maybe Vanguard FTSE Europe is a better choice. This fund is positioned in less volatile assets based outside the eurozone, mostly oil companies and labs, which have a more stable demand.

Be cautious here, though. ECB President Mario Draghi has promised to do whatever it takes to save the euro, but it's hard to think of stronger actions than the ones he's already taken. How much lower can the benchmark interest rate go? Not much more, so if these measures do not work, then the region could face serious trouble. Hence, considering that iShares MSCI Europe Financial is not 100% exposed to the euro, the fund remains interesting even in a pessimistic environment.

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Louie Grint has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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