EZ Deflation
Fundamentals Update as at 5 December 2013 by Lorenzo Beriozza
Relief that the EZ (Euro Zone) 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 enterprises in the periphery countries. There’s also concern about the impact that the US Federal Reserve (Fed) tapering might have on long-term borrowing rates in Europe, and what that might do to the pace of growth. Those are important worries – though the risks of the taper, for Europe, have 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 that much harder for the periphery economies to get a handle on their debt, or finally achieve self-sustaining growth.
In October the EZ inflation rate was 0.7% – the lowest in 4 years. The latest November flash estimate showed a slight rise, to 0.9%, but that still marks a significant step down from 2.5% in October 2012. The November figure will strengthen the general consensus that October will mark the trough, and inflation will stabilise over the next few months. But most forecasters expect EZ inflation to be below 1% 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, while Italy’s has fallen from 2.8% to 0.8% in the space of a year. One may sustain 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 so as 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% since 2009, and Spain’s productivity, measured by hourly output, has risen by more than 9% since the start of the crisis, while Spain has got rid of a 10% of GDP current account deficit in just five years. In 2014, the Organisation for Economic Co-operation and Development expects the country to run a 1.6% of GDP current account surplus. These are remarkable statistics. The problem for the EZ crisis economies is that this ‘internal devaluation’ has had to happen at the same time as governments have been grappling with that other urgent task, of stabilising their debts. A lower rate of domestic inflation might help with raising competitiveness, but it makes that 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 above-target inflation.
That inflation has been unwelcome to businesses and households, but it has at least allowed the cash level of GDP to keep on growing. That, in turn, has made the job of taming the public finances easier than in the European periphery. It has helped to smooth the process of private deleveraging, as well. 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 government borrowing). It goes without saying that it would be better to have a strong economy recovery 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 EZ 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, from a market standpoint, is that one should be wary of European investment strategies that assume an early and rapid resumption of earnings growth in the troubled economies in the months ahead, on the back of strong macroeconomic recoveries. There will be businesses that will thrive in the improved financial environment and can justify sharply higher valuations, but they are likely to be the exception rather than the rule.
The other broad investment conclusion is that the turn in the interest rate cycle, for the EZ, could be even further away than previously thought, and certainly a lot further away than in the US and the UK. Though the ECB’s staff continue to expect inflation to move back up towards the ECB’s target over the next year or so, their boss, Mario Draghi, has talked of the region entering “a prolonged period of very low inflation.”
However this disconnect is resolved, one can expect the ECB to be in easing mode for some time to come. The chances are probably that the EZ will avoid outright 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.
Source: JP Morgan Asset Management
