EuropeanJun 16 2014

Draghi’s deflation battle main focus for markets

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The issue of deflation in Europe has gradually become more of a threat, finally causing Mario Draghi and the European Central Bank (ECB) to act at its June meeting.

Figures from the EuroStat flash estimate set euro area annual inflation at just 0.5 per cent in May 2014, down from 0.7 per cent in April as energy and services both saw monthly falls.

The estimate put increased pressure on the central bank, resulting in a cut in interest rates from 0.25 per cent to 0.15 per cent, and a raft of monetary policy measures, including targeted longer-term refinancing operations (TLTROs) and preparation for outright purchases of asset backed securities.

In the related press conference, Mr Draghi noted: “The decisions are based on our economic analysis, taking into account the latest macroeconomic projections by Eurosystem staff, and the signals coming from the monetary analysis. Together, the measures will contribute to a return of inflation rates to levels closer to 2 per cent.

“Concerning our forward guidance, the key ECB interest rates will remain at present levels for an extended period of time in view of the current outlook for inflation. Moreover, if required, we will act swiftly with further monetary policy easing. The Governing Council is unanimous in its commitment to also using unconventional instruments within its mandate should it become necessary to further address risks of too prolonged a period of low inflation.”

Tom Becket, chief investment officer at Psigma Investment Management, notes: “Mr Draghi’s actions are targeted towards getting money flowing through the financial system and fixing the clogged arteries that are currently holding back growth. He has also basically suggested that the ECB might well create financial instruments so they can buy them themselves.”

Markets seemed to take heart from the measures, with the FTSE Eurofirst 300 recovering from an initial drop following the news to rally 2.5 per cent June 6. Meanwhile Germany’s Dax posted a 17.5 per cent gain early the following day, while the CAC 40 in France moved 4.46 per cent higher.

Serge Pizem, manager of the Axa WF Optimal Income fund at Axa Investment Managers, notes: “Markets should welcome this increased visibility and clarity on monetary policy, although other issues may now emerge, such as what the real demand may be for the proposed new liquidity measures for bank lending operations.”

But Azad Zangana, European economist at Schroders, warns: “Overall, the policy measures announced are helpful but do not significantly change the outlook for growth or inflation in the near future. In terms of forecast, we had expected a slightly larger cut in interest rates, but the additional measures present some upside risks. The extent of those risks depend on whether bank lending significantly improves and whether the euro can see a reasonable depreciation.”

Europe, however, is not the only market on the radar. China has been coming under increasing pressure from both the IMF and the World Bank on its credit growth, with both organisations warning of the need for reform. David Lipton, first deputy managing director of the IMF, states in the conclusion of the organisation’s Article IV consultation on China, that while the near-term outlook is “reasonably well in hand” there are underlying vulnerabilities and challenges that could threaten sustained rapid growth.

He adds: “Since the global financial crisis, activity has been too dependent on credit and investment, including in real estate. In the past year, the authorities have moved on several fronts to begin addressing these vulnerabilities, such as in ‘shadow banking’ and on local government debts, and we welcome these efforts. Nonetheless, continuing reliance on credit-fuelled growth means that risks are still rising, and although the government still has sufficient buffers to prevent a disorderly adjustment and sharp growth slowdown in the near-term, continued efforts to reduce vulnerabilities are a high priority.”

Nyree Stewart is features editor at Investment Adviser