EuropeanJan 13 2014

Deflation is real spectre looming on the horizon

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Relief that the eurozone has finally exited recession has come with strong gains in equity markets across the region.

After six consecutive quarters of declining output, investors are right to see some light on the horizon. They are also rightly impressed by the sheer scale of the economic adjustments that most of the crisis economies have achieved.

What could spoil the party? Many point to the low level of corporate lending and the challenge of getting credit to small and medium-sized enterprises in the peripheral countries. There’s also concern about the impact that Federal Reserve (Fed) tapering might have on long-term borrowing rates in Europe, and what that might do to growth.

Those are important worries – though the effect of tapering on Europe has probably been overstated. But one danger that investors should perhaps worry more about is that of deflation. That’s because very low – or negative – rates of inflation make it much harder for the peripheral economies to get a handle on their debt or achieve self-sustaining growth.

In October 2013 the eurozone inflation rate was 0.7 per cent – the lowest in four years. Most forecasters expect eurozone inflation to be below 1 per cent for much of 2014, and tend also to think that the risks are on the downside. In that kind of environment, it would be quite possible for inflation on the periphery to dip into negative territory, even if prices were rising in the area as a whole.

Greece and Cyprus have been living with falling prices for some time, and the Irish inflation rate has been hovering around zero for several months. Spain’s inflation rate was also zero in October 2013, while Italy’s has fallen from 2.8 per cent to 0.8 per cent in the space of a year.

You might say that low – or negative – inflation in these economies was a good thing. Isn’t it part of the necessary restructuring of these economies that they squeeze domestic prices and wages to rebuild their competitiveness? The answer to that is yes. But clearly there is a downside to all that restructuring in the form of shrinking domestic demand.

By 2014, Greek real wages will have fallen by more than 20 per cent since 2009, and Spain’s productivity has risen by more than 9 per cent since the start of the crisis, while Spain has got rid of a 10 per cent GDP current account deficit in just five years. In 2014, the Organisation for Economic Co-operation and Development expects the country to run a current account surplus of 1.6 per cent of GDP.

The problem – some would say, the tragedy – for crisis-hit eurozone economies is that this ‘internal devaluation’ has happened as governments have been desperately trying to stabilise their debts. A lower rate of domestic inflation might help raise competitiveness, but it makes the deleveraging job all the harder.

The UK has had the feeblest of recoveries since the onset of the crisis. But unlike most advanced economies, it has also seen a sustained period of inflation.

That inflation has been unwelcome to businesses and households, but it has at least allowed the cash level of GDP to keep growing. That, in turn, has made the job of taming the public finances easier than in the European periphery.

This may sound heretical, but it’s a matter of simple arithmetic. Since the deficit and debt are measured as a share of nominal GDP, anything that boosts the denominator (cash GDP) will make it easier to shrink the numerator (debt or borrowing).

It goes without saying that it would be better to have a strong economic recovery to push up the level of nominal GDP in these economies. But if that’s not on offer in an environment of structural reform and subdued regional demand, it’s all the more important to have at least a modicum of inflation to keep the cash value of the economy going up.

Investors are right to be encouraged by signs of growth in the eurozone, and the widespread belief that the periphery economies are past the worst. But the current very low level of inflation in the crisis economies could make it harder for them to achieve a self-sustaining recovery in the coming year.

The key takeaway is that one should be wary of European investment strategies that assume an early and rapid resumption of earnings growth in the troubled economies, on the back of strong macroeconomic recoveries.

The other broad investment conclusion is that for the eurozone, the turn in the interest rate cycle could be even further away than previously thought.

Chances are the eurozone will avoid deflation in 2014. But even the possibility that large parts of southern Europe could see falling prices next year ought to make policymakers very worried indeed.

Stephanie Flanders is chief market strategist for the UK and Europe at JP Morgan Asset Management

THE BULLS

Dean Tenerelli, European equities portfolio manager, T Rowe Price

“European equities are undervalued and the economies are recovering. Luxury-goods companies, banks in consolidated markets, broadcasters, and Spanish utilities are a few examples of where we see opportunity.

“The macroeconomic environment has transformed from an end-of-the-world scenario and fears of a eurozone break-up, to a story of improving confidence, modest recovery and improving company fundamentals.”

Asoka Wöhrmann, co-chief investment officer, Deutsche Asset & Wealth Management

“The ECB will play a crucial role this coming year. In 2014 we will not see restrictive monetary policy, but rather consolidation in the banking sector, something that is already concluded in the USA with more than 450 financial institutions being wound up.

“The term ‘banking union’ could well be one of the potential issues causing volatility in Europe. We expect inflation to be low, while there is no danger of deflation.”

THE BEARS

Bob Jolly, head of global macro, Schroder Investment Management

“Europe appears to be at least 18 months behind the US on the road to recovery, and it is currently stalling. Eurozone unemployment is around 12 per cent and is likely to go up rather than down.

“One of the reasons growth is not accelerating is that banks are unwilling to lend to companies as they fear the risk of defaults and blowing even bigger holes in their balance sheets.”

Trevor Greetham, director of asset allocation, Fidelity Worldwide Investment

“Falling inflation in the eurozone is putting pressure on the ECB to ease further, with negative deposit rates and some form of quantitative ease under discussion.

“We remain underweight in Europe, although to a lesser extent than at the height of the crisis. A return of confidence has reduced the pressure to complete fiscal and banking union. Earnings revisions remain negative and political tensions are likely to return when the world economy next hits a weak patch.”