Easy Money In Europe Means Big Profits For This Sector

One mantra has overridden everything else for the past five years. It has proved even the most astute bears wrong and made money for anyone with a dime in the markets. 

#-ad_banner-#Don’t fight the Fed!

Stocks have jumped every year since 2009 — and every year pundits say we are due for a major correction. Subpar job growth and annual GDP growth under 2% cannot possibly support asset prices, they say, and a slowing China can’t pick up the slack.

And every year they are wrong.

Why? Because for the past five years, we have had the most influential central bank in the world saying they’ve got a monetary defibrillator… and they’re going to keep shocking the economy until it jumps back to life.

The economic resuscitation has been in the form of more than $3 trillion pumped into the system.

While the general economy may still seem to be on life support, asset prices have more than doubled since the Federal Reserve began its assorted quantitative easing (QE) programs. 

What’s Next?
As Fed winds down its historic monetary support, I can’t help but wonder: What’s next for stocks? Fortunately for investors, it looks like the game will be the same — but instead of “Don’t fight the Fed,” the next slogan will be…

Don’t fight the ECB!

About two years after President Mario Draghi told the markets he would do “whatever it takes,” the European Central Bank is about to give the market a shot of adrenaline. At its June meeting, the ECB said it would initiate another round of cheap loans, up to $544 billion to regional banks. The loans will have four-year maturities and cost just 0.25%. 
Beyond its assorted loan programs, the ECB has lowered rates into negative territory, giving banks an extra incentive to increase lending rather than sit on cash. If even this were not enough, the International Monetary Fund recently urged the ECB to initiate an asset purchase program as well.

The Government’s Shell Game — With Money Under Every Shell
While the new ECB’s loan program may do no better at kick-starting the economy than the Fed’s program did here in the U.S., one sector is almost guaranteed to benefit. J.P. Morgan estimates that only 5% of the original loan program actually made it into the economy, with the rest used by the banks to buy sovereign debt and retire costlier loans. 

Banks were able to borrow more than $1 trillion at a rate of just 1% to buy bonds with yields two or three times higher, and the ECB said nothing. Now, the banks are getting an even better deal with a longer loan at a lower rate

For example, under the new program, a bank could borrow at 0.25% and buy Italian 10-year debt yielding 2.9%. Unless you believe that Italy will default, that is a 2.6% riskless return. That is the risk-free scenario, but it gets better.

A strengthening economy across the European Union may actually see the banks increasing loans (as the program intends), which could see even higher profits. While the region’s economy may not be growing as fast as in the U.S., the downside risk has been greatly diminished. and there’s a good chance that banks will put more of the new targeted loan program to work.

While American depositary receipts (ADRs) of European banks are limited, investors can still cash in on the new market mantra. 

Deutsche Bank (NYSE: DB) is one of the largest banks in the region, with a market cap of $36.2 billion. The bank is global in operations and so may not benefit as much as other strictly regional banks though 30% of 2013 revenue was from retail and business clients. Shares increased 19.0% in the first year of the ECB’s three-year loan program. 

However, shares have plummeted 26% during the past six months on allegations of market manipulation and a proposed capital raise. That pullback means DB may now be an especially good value. Shares trade for less than half book value (0.47 times, to be exact), compared with the industry average of 0.9 times. 

The iShares MSCI Europe Financials Sector Fund (NYSE: EUFN) holds positions in more than 100 financial institutions across Europe, many of which are not accessible as ADR shares to U.S. investors. The fund holds its largest exposure to U.K. banks (31.3%) but diversifies the rest of the holdings across EU members. The fund jumped 36.2% in the year after the ECB’s first loan program, but it has fallen 4% in the past six months. Shares pay a biannual dividend with the June payment doubling the distribution from the previous year. The average price-to-book ratio is relatively expensive at 1.3, but book values are likely to improve on the new round of ECB funding.

Risks to Consider: Despite increasingly easy money from the central bank, the eurozone is still only expected to post GDP growth of about 1% this year, which could make it difficult for financial companies to generate long-term profits. 

Action to Take –> The ECB is again handing out virtually free money to the region’s banks and permitting them to make nearly riskless money in the carry trade or generate higher profits on loans. Take advantage of that generosity ahead of the rest of the market for a potential pop in shares.

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