Did ECB President Mario Draghi fire his policy bazooka for a final time?

Economic data took the lead last week as U.S. stocks continued their sharp rebound off 2016 lows. The rebound in European stocks, though, has owed largely to expectations for further monetary stimulus from the European Central Bank (ECB). The much-anticipated March policy meeting arrived Thursday, and the ECB over-delivered on all fronts with corporate bond buys, more government bond purchases, a cut to the deposit rate and, most notably, lower rates for targeted longer-term refinancing operations (TLTRO).

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The ECB decided to launch four rounds of TLTRO (which are effectively long-term loans to banks) at 0% interest rates, with the kicker being that LTRO rates actually go negative, i.e. banks get paid by the ECB to take loans, by as much as 0.4% if banks meet certain lending thresholds. Meanwhile, the deposit rate was cut from -0.3% to -0.4%, meaning banks get charged to park money overnight at the ECB - get paid to borrow and lend, get charged to deposit and save. The ECB isn't being subtle about creating incentives. 

Several global central banks have attempted to grease credit markets and stave off deflation with negative interest rates, but analysts have grown increasingly concerned about the potential for unorthodox policy to impair bank balance sheets and cause greater instability. The negative rates on LTROs help offset the costs of negative deposit rates, which is why as markets got a chance to digest the stimulus package overnight, eurozone financial stocks exploded higher Friday.

The other curveball from the ECB was its decision to expand eligible assets in its monthly quantitative easing (QE) purchases to include non-financial sector investment-grade corporate bonds.

However, just as the risk asset bonanza was set to commence Thursday following the policy decision, ECB President Mario Draghi called the cops on his own party, suggesting that the central bank had fired its bazooka for the final time. Stocks, which had initially traded sharply higher, came crashing down into negative territory by Thursday's close, and the euro, after initially falling 1.5% against the dollar, closed the day up almost 2.0% against the greenback. The initial post-decision trends resumed Friday, however. 

Draghi basically told the market to be grateful for the gift it received today because there is no guarantee it will get anything tomorrow, and investors were briefly spooked by the idea. But Mario Draghi is a doting parent, the market his spoiled child. If it ever gets into any real trouble in the future, the market knows deep down Daddy will always be there to support it. 
 
Low-cost indexing: too much of a good thing?

After the financial crisis, the Fed reflated asset prices by cutting interest rates to 0% and introducing quantitative easing (QE). Those policy decisions led to a period of dramatic outperformance for passive indexing strategies and, in turn, sparked a flight into index funds. The trend shows no signs of abating as active managers had downright lousy performance in 2015.

Around 20% of stocks are now owned by index funds, significantly more if you count “closet indexers.” The growth of indexed assets has created a set of dilemmas not only for financial markets, but also the economy. From a market perspective, established companies with the largest market caps benefit disproportionately from their place within indexes. Greater value might now exist outside of indexes, but that value will go unrealized if there isn’t any demand for those stocks. Patrick O’Shaugnessy also astutely asks, “if indexes are now primary targets, are they still good measures of stock market performance?”

Secondly, investors once bought stocks based on factors like profitability, growth and management performance, but today a large swath of investors have no incentive to encourage competition among the companies that make up their highly diversified portfolio. Declining productivity is largely the reason the 14 million new jobs created since the financial crisis haven’t translated into robust GDP growth. In that vein, The Atlantic's Joe Pinsker asked, “why is flying still expensive even though fuel’s gotten so cheap?”

Fortunately for indexers, activist investors are still around to do their bidding. But as index fund ownership of stocks grows, there could come a time when activists have less capacity to hold corporate boards accountable. That’s why many investors were alarmed at the secret summit of the world’s largest asset managers earlier this year. The purpose of the meeting was apparently to “hammer out proposals for improving public company governance to encourage longer-term investment and reduce friction with shareholders,” which is code for ‘stop activists from raining on the indexing parade.’

Even active managers acknowledge that low-cost indexes are a valuable core for a diversified portfolio, but you can have too much of a good thing.
 
China’s trilemma

China’s National People’s Congress (NPC) held its annual meeting this week, with global economists watching intently to see whether the parliamentary body would prioritize economic growth, structural reforms or the stabilization of financial markets. The NPC decided it would rather just have all three. Moody’s called it an “impossible trinity.” Not to be outdone, former Fed Chairman Ben Bernanke dubbed it China's trilemma.

The Chinese government’s latest plan to cope with non-performing loans is to introduce legislation allowing commercial lenders to swap bad debt for equity stakes in creditor firms. While such a solution allows banks to cosmetically improve their balance sheets, it does nothing to solve the fundamental problem of huge industrial overcapacity and could actually make the crisis more systemic over the long-term. At some point the Chinese government is going to have to grin and bear the effects of a massive non-performing loan cycle and allow the yuan to depreciate significantly. But for now, Chinese policy makers are showing little appetite for allowing large-scale capital flight, prompting several hedge funds to back off bets on China currency devaluation.
 
Oil dawn

Oil again helped drive this week’s rally, with the International Energy Agency (IEA) saying Friday that oil might have bottomed as production declines accelerate in the United States and other non-OPEC producing countries and Iran's production ramp has been smaller-than-expected. They’re not the only ones who feel like oil prices have turned a corner, but that doesn’t mean heavily indebted oil companies are out of the woods. In a blow for energy infrastructure firms, a judge set a precedent this week by allowing an American oil and gas company to abandon its pipeline contracts in bankruptcy.  
 
Labor fighting back against capital

For the past 35 years, labor’s share of U.S. national income has steadily declined, disproportionately hurting the lower and middle classes. The trend had Goldman Sachs “questioning the efficacy of capitalism, but fresh analysis from Goldman's Elad Pashtan's is sure to instill renewed faith in the Invisible Hand for any colleagues that had begun to have creeping doubts.”

The FinTech dilemma

Even if they won't admit it, wet-behind-the-ears FinTech firms are starting to realize they are financial institutions in new clothes. This week SoFi moved to boost its capital position and lending capacity by starting a hedge fund that will buy its own securitized loans.

Meanwhile, legacy financial firms don’t want to be left behind by the FinTech revolution. After demoting his long-time lieutenant at a Bridgewater tribal council earlier this year, Ray Dalio hired an ex-Apple executive as his new co-CEO.

Brazil gets tough on corruption

The political scandal gripping Brazil continued to deepen this week as former Brazilian president Luíz Inácio Lula da Silva was charged with money laundering and concealing ownership of assets. Marcelo Odebrecht, former CEO of South America’s biggest construction company, was also sentenced to 19 years in prison for money laundering, corruption and organized crime. The pressure is building on President Dilma Rousseff, who chaired the Petrobras board before becoming president, to step down, although she continues to dig in her heels.
 
Bull market's unromantic anniversary

The market celebrated its seven-year bull market anniversary this week, but not everybody was in a celebratory mood. The fact this bull market remains so unloved could be the very reason why it will continue. Meanwhile, Wall Street is wrestling with the notion the seven-year run could have been built on smoke and mirrors of suspect non-GAAP earnings reports and buybacks. 

In other news

A mysterious trader named the “the dude” has moved markets and rattled Turkish investors with massive bets.
 
Bloomberg released the latest in its "ETF Files" series explaining how ETFs work and how the government inadvertently launched the $3 trillion industry.
 
Junk bonds are getting junkier, but their recent comeback is a sign investor fear is subsiding.