Rhetoric is the eurozone’s sole policy tool. Mario Draghi made this work in spectacular fashion in July 2012 with his now famous speech that the European Central Bank (ECB) would do “whatever it takes” to save the euro.
If confidence in the recovery falters, then the default response is now to talk reassuringly to markets about potential policy action. Indeed, the main highlight of Mr Draghi’s comments at this April’s ECB press conference was his assurance that “rich and ample discussions” had taken place around quantitative easing. The euro duly rallied, then fell on these Delphic utterances, as one analyst quipped “euro traders left clueless as Draghi threatens nothing”.
But all the hot air cannot hide the fact that there have been no new policy initiatives launched. While the euro might have come back modestly from a new high for the year in mid-March, it nonetheless remains a resolutely firm currency.
There are two powerful forces at work that could compel the ECB into action. Firstly, ongoing euro strength would force even the most orthodox German policymaker into worrying about the exchange rate strangling European growth.
Devaluing policies
In a world of competitive devaluations, currencies have become an important policy tool and the ECB seems to be losing this battle by default through inaction. By being the last mover in this competitive game, it is far from clear that engineering a weakening of the euro against its main trade partners can be achieved, as other central banks have been far less reticent about taking decisive action than the ECB.
At present, a stronger euro is combining with lower peripheral bond yields to create a preference for domestic companies over international plays. Any reversal in the strength of the currency could see the exporters swing back into favour, especially as they have experienced a significant de-rating during the past two years or so.
The second reason for the ECB possibly loosening the monetary reins could be inflation.
The path of German bond yields is ominously following the pattern set by Japan in the 1990s, when the Japanese sleepwalked into deflation, as the Bank of Japan remained persistently behind the curve on policy action.
While the risk of outright deflation across the eurozone is still low – though not negligibly so – it nonetheless illustrates the challenges for policymakers in a competitive world. There is no evenness in how economic variables play out across the eurozone and deflation in one country is entirely compatible with rising prices in another.
The inability to engineer a lower euro has forced an internal devaluation on many countries. This creates an imperative for necessary but painful structural reforms, leaving behind a painful legacy of high unemployment and elevated government debt levels. These debts will continue to expand as real yields are not falling at the rate that nominal yields suggest. It is real yields that matter to governments as higher inflation would erode away the real value of their borrowings, and this is not happening.
While there is no denying the cyclical recovery in Europe, and one that is benefiting the periphery more than the core at present, the challenge at the stock level is coming from agonisingly low levels of nominal GDP growth.
Imbalanced bounce back
An absence of inflation is limiting the potential for a strong rebound in sales growth, which is why the recovery has been so uneven and unexciting thus far. Positive surprises in reported sales numbers continue to lag behind profit figures, suggesting that cost cutting is still at the forefront of the corporate mindset. High energy costs in Europe are an additional challenge for European companies and a drag on growth.
With no significant aggregate increase in productivity through innovation, it is down to initiatives at the company or industry level to generate pockets of growth. This is why cost cutting and internal deflationary pressures will remain a feature for some time in Europe.
Any introduction of quantitative easing is an added benefit to the European story and is not an essential element for the region. But weak pricing power ensures that not all companies can be winners, so careful stock selection remains paramount. Disinflation and low productivity growth combine to ensure that this is a far from ‘normal’ recovery.
Andrew Parry is chief executive of Hermes Sourcecap
