The Eurozone may be headed for stagnation: Fidelity.

When pessimists want to express the utmost gloom ahead for the eurozone they often cite Japan’s lost decades as their most-feared outcome for the 18-member area.

The worriers invoke a familiar tale when they talk of Japan’s endless stagnation since an asset-bubble popped from 1989. From the early 1990s, real estate values and stock prices plunged and banks wobbled under bad debts. Even though Japan’s export success persisted, the country’s economy failed to flourish despite massive fiscal stimulus, interest rates being slashed to almost zero and the invention of quantitative easing. A potent symbol of Japan’s malaise is that deflation became entrenched from 1995 to 2013 (with the exception of 1997).[1]

Europe’s economic performance is so lacklustre that the financial crisis that European Central Bank President Mario Draghi doused in mid-2012 with his “whatever it takes” pledge has become an economic and political crisis. The eurozone recorded no growth in the second quarter, when the Germany and Italian economies shrank 0.2%. Deflation is shadowing the region. Eurozone prices only rose 0.3% in the year to September, deflation having already taken hold in eight countries including Spain, Italy and Portugal. Deflation would prove Ebola-like for the eurozone because net government debt now amounts to 87% of output. All but two euro-users have net government debt ratios above the prescribed rate of 60% of output, while the number where net public debt exceeds GDP is six, now that Belgium (102%) has reached the triple figures that make default a possibility for a slow-growth economy. Unemployment for the eurozone is 11.5%, and soars as high as 27% in Greece and 24% in Spain. Eurozone banks reek with bad debts and are reluctant lenders. Needless to say, the economic calamity is poisoning politics. So is Europe heading for Japan’s popularly ascribed fate? You bet. But there are two twists when comparing the eurozone’s fate to the story of Japan’s lost decades. One of them may surprise investors. The other could calm their concerns.

There is always hope that eurozone policymakers will do more to resurrect their economy and puncture the pessimism. The split in France’s ruling Socialist Party over imposing austerity could spark a welcome backlash among euro users against the self-defeating fiscal straightjacket enforced by Berlin, whose resistance may weaken as Germany’s economy stagnates. The ECB, watching the collapse of inflation expectations, is sending signals that it will launch a quantitative-easing, or full-blown asset-buying, program before too long. Perhaps authorities will heed the calls from respected economists that, to boost growth, central-bank-financed fiscal stimulus is justified (real money printing via fiscal policy and a surefire way to generate inflation). The more the economic crisis intensifies, the greater the pressure on politicians to compromise over the political, banking, fiscal and other integration the eurozone needs to surmount its debt crisis and secure the euro’s future. The problem for the eurozone is that politically viable remedies, such as relaxing fiscal targets and quantitative easing, are only half-hearted solutions while true cures appear politically impossible. Thus the lost years since 2008 will turn into a lost decade soon enough.

The despair

Almost incredibly given the woes of the eurozone economy, many media reports and commentators refer to a eurozone recovery because they use the flawed system of judging the business cycle by looking at growth from one quarter to the next. (The flipside of this misleading oversimplification is to define a recession as two consecutive quarters of negative growth.)

The best way to adjudicate economic performance is to look at how an array of indicators such as output, employment, income growth, industrial production and retail sales perform over time. This is the flexible method by which the National Bureau of Economic Research declares recessions and expansions in the US to no dispute, often well after the troughs and peaks in activity have occurred. The same method is applied to the eurozone by the UK-based Euro Area Business Cycle Dating Committee. This body, rightly, won’t declare the eurozone out of recession even though its economy has expanded during four of the past five quarters. In a sense, what the body is saying it that it’s too early to say that activity has troughed.

While such informed judgements of business cycles are the most credible way to call recessions and expansions, they don’t readily allow for comparisons across regions or time. The best way to do that, for all its flaws is firstly to look at how long an economy takes to regain its previous peak in output in gross and per-capita terms and, secondly, to calculate the maximum drop in output over a recession. On this basis, for instance, the US regained its 2007 output peak in 2011 in gross terms and two years later on a per-capita basis. The worst of the downturn was in 2009 when GDP was 0.7% below 2007’s level. The US economy is thus rightly described as being in recovery, for output in 2013 was 5.9% above the level of 2007. (The National Bureau of Economic Research will call the end of a recession before GDP has fully recovered its previous peak when comparing quarterly output. It dates the most recent recession as ending in the June quarter of 2009 when GDP was 1.3% below that of the fourth quarter of 2007. It made this decision 15 months after the trough in activity occurred.)[2]

The eurozone’s GDP peaked in 2008 at 13.6 trillion euros (A$19.3 trillion) and it is yet to regain such heights for 2013’s output was 1.8% below the pinnacle of 2008. The worst of the slump occurred in 2009 when the eurozone’s GDP was 4.4% below the height reached the previous year. The IMF, which does not provide GDP-per-capita figures for the eurozone, predicts that the eurozone’s GDP will only regain its 2008 apex in 2015.[3]

Among the three biggest and most populous eurozone economies, Germany regained its 2008 peak in 2011 and by 2013 its economy was 2.3% above the highs of five years earlier. France reclaimed its 2007 high point in 2011 but by 2013 its economy was only 0.1% above its level of six years earlier. Alas, Italy’s GDP in 2013 was 9% below the record it set in 2007. On a per-capita basis, only Germany is ahead, having clawed back to 2008 levels by 2011. By 2013, Germany was 4.9% ahead on this, the best, measure of prosperity. Last year, France’s GDP per capita was 2.3% below its record of 2007 while Italy’s was 11% under on this basis.[4]

How does this compare with Japan? This may well be the surprise. Japan’s economy expanded in 16 of the 18 years from 1990 to 2007 – it contracted 2% in 1998 and shrank another 0.2% the following year – so there was never post-crisis drop in output. In the decade after the asset bubble peaked in 1989, Japan’s economy swelled 15.5% in gross terms. On a per-capita basis, Japan’s expansion was 12% over these 10 years, while the jobless rate only ever got as high 4.7% over that time, in 1999.[5]

Admittedly other economies outshone Japan over this period – Australia recorded 24% per-capita growth from 1989 to 1999, the US 22% and Germany 17%. But the figures for Japan show that talk of a lost decade in the 1990s is an exaggeration to say the least.

The same goes for the following 10 years. After the slight dip in 1999, Japan’s economy grew every year from 2000 to 2007, even though, it’s worth pointing out, the country was in mild deflation from 1999 to 2005 – the annual decline in consumer prices averaged 0.5%.[6] (The GDP deflator would show deflation stretched from 1998 to 2013 but it’s real economic growth that counts.) All up, from 1989 to 2008, Japan’s GDP jumped by 29%. The country’s output swelled 24% over these two decades on a per-capita basis. The highest the jobless rate ever climbed over these two decades was to 5.4%, in 2002.

Nobel-Prize-winning Paul Krugman is among those who call talk of Japan’s two lost decades a “myth”. He found that using GDP per working-age population – an adjustment that takes account of Japan’s shrinking and aging population – Japan recorded “not bad” growth of 1.2% a year from 1990 to 2007.[7]

If anything, Japan’s worst economic patch since 1989 has been the past six years because its economy contracted in 2008, 2009 and 2011. But since 2007, Japan has still performed better than the eurozone for by 2013 Japan’s GDP had regained its 2007 peak.

The consolation

Europe’s economy is thus already worse than Japan’s in just about every way, even if Tokyo’s net government debt stands at 144% of GDP.[8] So too is its political and social situation. Japan has its own currency and monetary policy (including its own central bank) and can make its own decisions on fiscal policy rather than operate within constraints set by Brussels. Asia’s second biggest economy is still a strong exporter. Government debt in the country is largely owned by locals, which helps insulate the country against foreign speculators. Japan has beaten deflation, for now at least, as consumer inflation excluding food reached 3.1% in the 12 months to August. Japan is a homogenous country, even if an aging one. It is politically stable and its low unemployment has never allowed extremists to flourish.

Sadly, the best comparison for the eurozone’s stagnation is the 1930s. As Nobel-Prize-winning economist Joseph Stiglitz says: “The only way to describe what is going on in in some European countries is depression.”[9] Even more startling perhaps, in terms of time taken to regain the previous peak, the eurozone is on track to surpass the worst-performing group of countries of that era; those that stayed on the gold standard, the closest thing to a fixed-currency regime as damaging as the euro. (The euro is worse because it’s proving impossible to quit.) The eurozone has already overtaken the time taken for the gold quitters of that era to recover.

Work by UK economic professor Nicholas Crafts shows that the group of European countries that stayed on the gold standard – Belgium, France, Italy, the Netherlands and Switzerland – while admittedly suffering a steeper contraction of 10%, took 7½ years to recover their previous group peak. In comparison, the so-called sterling bloc, namely Denmark, Norway, Sweden and the UK that quit the gold standard, only took 4 ½ years to recover. The eurozone’s downturn is five years old as of 2013.

But that doesn’t mean that stock investors should despair (though Europe’s unemployed can be forgiven for being despondent). There is something to the Japan story to calm investors. This comfort is how well the global economy and global share markets coped with the troubles of the world’s then-second-largest economy and the collapse of its stock market.

At the end of 1989, Japanese stocks accounted for 41% of the MSCI World Index.[10] After the Nikkei 225 Stock Average fell 80% from its peak on 29 December 1989 to its post-bubble low on 31 March 2003, Japan’s weighting in the MSCI World fell as low as 7.8% in May of that year.[11] How did global stocks fare over that time? They rose. The US S&P 500 Index surged 140% over those 14 ½ years, helping the MSCI World Index in US dollar to climb 32% over the period.

However you assess Japan’s economic performance over the decades after its bubble popped, these returns show that the global economy and a portfolio of global stocks can survive the stagnation of a big economy if the US economy is doing well enough, other parts of the world are expanding and no shocks emerge. As long as the woes of Europe don’t lead to jolts and no other shudders emerge, a US recovery and decent performance elsewhere – including in Japan! – should be enough to propel global stocks in coming years. By then, the most pessimistic outcome you could paint for a modern developed economy would be that it’s facing lost decades like the eurozone.

by Michael Collins, Investment Commentator at Fidelity

All GDP figures are real. As footnoted, GDP and GDP-per-capita figures come for the IMF World Economic Outlook Database. April 2014. http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/index.aspx.

Figures on eurozone consumer inflation, unemployment and government debt come from Eurostat (http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home). Other financial information comes from Bloomberg unless stated otherwise.

The post Is Europe headed for “Japanese-style” stagnation? appeared first on AdviserVoice.

Michael Collins

Search around Europe and encouraging signs emerge amid the immense unemployment and political agitation. The eurozone economy expanded 0.3% in the three months to December, to mark three straight quarters of growth after six of shrinking.

Confidence and business indicators are rising – the Markit purchasing managers index is close to a three-year high. The combined fiscal deficits of eurozone governments in 2013 fell to the target 3% of GDP for the first time since 2008. The 18-country bloc is recording its biggest monthly current-account surpluses in five years. Officials have made progress on a banking union. Greece in April sold its first government bonds since its default two years ago, at the lower-than-expected effective rate of 5% compared with 30% in 2012, while Portugal’s first bond sale since its rescue in 2011 was oversubscribed too. Sovereign yields for the bailout countries are at their lowest since 2005. European government and corporate debt is trading at its narrowest spread over benchmark German equivalents since 2007. Moody’s Investors Service reports that credit rating upgrades for the March quarter outdid downgrades for the first time in more than six years. Equities have jumped on the promising signs – the STOXX Europe 600 Index has rallied more than 26% since mid-2012.[1]

July of two years ago is taken as the point when confidence in Europe improved for that’s when the European Central Bank pledged to do “whatever it takes” to save the euro. These words instilled a belief that the euro will survive a crisis in its fifth year. But this optimism has spawned a fresh peril. This is the more-than-15% rally in the euro over the past 22 months to just below 1.40 to the US dollar – 1.3934 on March 18 is the euro’s post-crisis high compared with 1.2061 on 24 July 2012. The surge in the currency creates two dangers. The first is that it undoes the region’s improved trade competitiveness. More alarming, the mighty euro is fanning deflationary forces as it lowers the price of imports. Deflation is a poison for such an indebted region and could place the single currency under threat again.

European policymakers have remedies at hand; above all, quantitative easing by the ECB. Ideology and practical limitations, however, make this cure problematic. The questions for investors are whether the ECB will launch an asset-buying program in time and whether one would prove effective in rekindling economic growth and staving off deflation.

The bloc’s problems are far bigger than just a strong euro, of course. The economic crisis has spawned a nationalistic revival that makes it harder to achieve the political union a common currency needs to survive. A generation of young is being lost to joblessness. The worsening debt-to-GDP ratios of many countries could spell default sooner than later without deflation – “lowflation”,[2] as the IMF calls it, is as toxic for a region where net government debt stands at 96% of GDP.[3] Austerity is a bigger cause of disinflation than the strong euro anyway, for in a fixed-exchange-rate regime lowering wages and other costs is the only way to regain competitiveness within the bloc. A drop in global energy, commodities and food prices is putting downward pressure on inflation, so the villain’s not just the rising euro. Some people argue that, while eurozone inflation is too low, the ECB will still meet its inflation goal of keeping price rises to below, but close to, 2% over the medium term.[4] The Federal Reserve could remove much upward pressure on euro by accelerating the end of its asset-buying, which would boost US interest rates and thus the US dollar. These factors, though, don’t mitigate against the facts that the high euro limits Europe’s ability to trade its way out of the doldrums and could be the final shock that enshrines deflation. It shows the conundrums, or even the hopelessness, facing eurozone policymakers – even their successes generate a bigger risk of failure.

Upwards and backwards

The euro is rising for a number of reasons that show no sign of abating. One cause is that the eurozone’s inflation is below that of its trading partners. Eurozone prices only rose 0.7% in the 12 months to April (after being as low as 0.5% in the 12 months to March) while the latest readings show annual inflation in Japan, the UK and the US was 1.6%, 1.6% and 1.5% respectively and is higher in most other countries. Docile inflation supports a currency because, in theory, exchange rates should adjust for inflation over the long term to keep the real costs of goods steady across countries.

A second force is the eurozone’s improved trade performance. Austerity has crippled domestic demand in bailed-out Europe, and thus fewer imports are flowing in. At the same time, austerity has reduced labour and other costs, making exports more competitive. The current-account surplus of the eurozone stood at 2.9% of GDP last year, compared with a deficit at 0.7% of output in 2007.[5] Trade performance is another fundamental determinant of exchange rates for it governs the balance of demand for a currency between importers and exporters.

The third reason behind the strong euro is that Europe’s interest rates are higher than elsewhere. Lingering uncertainties about peripheral countries mean their bonds are trading at premium yields over equivalents in Japan, the UK and the US where central-bank asset buying has lowered interest rates. This promotes the so-called carry trade where investors borrow in the currency of a country with low interest rates to invest in higher-yielding euro-denominated securities (while hoping exchange rates don’t move against them). A fourth reason propping up the euro is that European banks are understood to be selling foreign assets and converting the proceeds to euros to bolster their balance sheets to meet capital ratios.

On top of these reasons sits the confidence that the ECB has rescued the euro. This optimism is inspiring the bond buying that has driven down yields on European government and corporate debt from their crisis highs. It is encouraging other investment flows into the eurozone, even into the bailed-out countries. Other sources of demand for European securities and thus the euro are investors fleeing emerging markets, central banks diversifying their foreign-exchange reserves away from US-dollar denominated assets and investors pouncing on cheap euro-priced assets. Foreigners drive up the euro when they buy euro-denominated stocks, debt and other securities because they need to convert their currency into euros to take hold of the assets.

Many European officials have voiced concern about the high exchange rate. Jean-Claude Juncker, a leading candidate to be EC president this year, warned as he stopped presiding over meetings of European finance ministers in January 2013 that the euro was “dangerously high” when it was 1.34 to the US dollar.[6] More recently in March, Herman Van Rompuy, the president of the European Council, said that the euro is “too strong for our exporters”.[7] In April, Belgian Finance Minister Koen Geens warned the strong currency “creates a risk of deflation”.[8] In central-bank jargon, ECB President Mario Draghi echoed the same concern when he spoke of the euro “becoming increasing relevant in our assessment of price stability”,[9] which is the ECB’s only goal. (Unlike the Fed and the Reserve Bank of Australia, the ECB is not charged with fostering full employment.)

Decision time

The pressure on the ECB to haul in the euro is building. Draghi on May 8 said the high euro was “a serious cause for concern” and promised action at the ECB’s next policy-setting meeting in June when the central bank releases its next inflation forecasts. “The governing council is comfortable with acting next time,” he said, after the council just met and made no change to monetary policy.[10]

The big jolt for the euro would be if the ECB mimics the Bank of Japan, the Fed and the Bank of England by implementing a quantitative-easing program. Among other options are negative interest rates on bank deposits with the ECB to encourage banks to lend the money instead or pruning the cash rate from its record low of 0.25%.

Until now, political constraints have stopped the stateless ECB from expanding its balance sheet to buy assets. The biggest opposition has come from inflationphobic Germany (even though such programs barely budge inflation, for quantitative easing is not printing money, which falls under fiscal policy even if it requires the help of a central bank). Since the eurozone crisis erupted in 2009, two Germany central bankers have quit the ECB, in part due to their hostility towards asset buying in forms that fall short of quantitative easing. In 2011, Alex Weber resigned as president of the Bundesbank, a role that sits on the ECB’s policy-setting board, and Jüergen Stark quit as ECB chief economist because they said the ECB was acting outside its mandate when buying small amounts of sovereign debt of struggling countries on the secondary market to drive down interest rates. These purchases weren’t under the guise of a quantitative-easing program because they were sterilised – the ECB took counteracting steps to keep the money supply steady, whereas quantitative easing expands the monetary base.

Weber’s successor as head of the Bundesbank, Jens Weidmann, has spoken out against many of the ECB’s attempts to stabilise the eurozone. He opposed the ECB’s powers to buy unlimited amounts of bonds under its yet-to-be-implemented-or-even-detailed Outright Monetary Transactions program, the scheme that enforces Draghi’s promise to save the euro, a program under which bond buying of deadbeat sovereigns would be sterilised. But as threats shift so too is Germany’s thinking. The danger of deflation, even in Germany, prompted Weidmann on March 25 to concede that quantitative easing “isn’t generally out of the question” when considering the legal restrictions on the ECB.[11] (Five of the 18 euro-using countries suffered deflation in the year to March.)After the ECB policy-setting meeting on April 3, Draghi announced that board members were “unanimous” in backing “unconventional instruments within its mandate” such as quantitative easing to keep deflation at bay.[12] The extent and form of any such asset-buying are open questions, though, as is what would prompt the ECB to sanction such a step.

The euro has nudged up a touch amid all the ECB comments about quantitative easing because forex traders are dismissing Draghi’s talk as just that. At the same time, bond investors are pricing in a massive ECB buying spree (a trillion euros) and will be disheartened if political or any other constraints limit any ECB purchases. Hardliners in the stronger countries oppose measures that take pressure off bailed-out countries for they claim they will go slow on reforms that boost competitiveness. Nationalistic forces will oppose handing more power to a central authority such as the ECB. Countries, especially Germany, could face legal restrictions if their central banks take part in any quantitative easing by the ECB. Any ECB quantitative easing will probably be far more limited than, say, the Fed’s three bursts, which have quadrupled the US central bank’s balance sheet to US$4 trillion (A$4.3 trillion). If the ECB undertakes quantitative easing, it has debt from 18 governments to choose from, another political headache. The weaker countries with deflation have less liquid debt markets, which makes it trickier for the ECB to act where it can do the most good. Stronger-but-still-challenged countries such as France have more muscle to ensure their bonds are targeted instead. The ECB is understood to be keen to buy private assets such as asset-backed securities because such purchases would have greater chance of boosting lending to businesses in rescued countries. But such markets are illiquid and small, making pricing problematic and reducing any economy-wide effects. A side effect of quantitative easing would be to boost the value of bonds on bank balance sheets, possibly distorting the ECB’s stress tests on banks it will soon supervise. Emerging countries may well accuse the ECB of engaging in currency wars.

The ECB board members and national governments could easily fall out over these issues and no program is launched. On the other hand, if eurozone inflation readings head up the ECB will happily do nothing. After all, even in the middle of a jobless crisis, why do anything when under the cursed euro even achievements proved jinxed?

by Michael Collins, Investment Commentator at Fidelity

————-

Financial information comes from Bloomberg unless stated otherwise.

The post The latest threat to the euro? appeared first on AdviserVoice.

Bond markets are full of surprises. Core government bonds have been one of the strongest performing asset classes in 2014, propelled in part by worrying signs of emerging market stress.

Emerging market (EM) debt has suffered relentlessly for nearly a year, scant reward for those emerging economies that spent most of the last decade bolstering their finances. Meanwhile, in the eurozone, Greece, Portugal, Spain, Italy and Ireland are among the world’s most indebted countries, and yet their bond markets have witnessed one of the most explosive rallies in history. Is this fair, and what explains this dichotomy?

The post Does debt matter? The diverging tales of the eurozone and the emerging markets appeared first on AdviserVoice.

Europe slides towards deflation

Greece, as is often the case, is a bellwether for all that is going wrong in Europe. Among the latest woes for an economy that has contracted for six years straight is deflation.

Greece has battled deepening deflation since reports showed prices fell 0.2% in the year to March.¹ By the 12 months ended November, deflation was running at an annual pace of 2.9%, thanks in no small part to a jobless rate of 27% triggering a 12% plunge in wages.

In recent months, the list of eurozone economies suffering from annual deflation peaked at four; Cyprus, Ireland and Latvia, which started using the euro on January 1, are the others featured. This deflation roll threatens to expand because in November prices dropped in Belgium, Estonia, Italy, Luxembourg, Malta, the Netherlands, Portugal and Slovenia, while prices were flat in France, Finland, Slovakia and Spain. (See table below.) For the eurozone, prices slid 0.1% in November and only rose 0.9% in the 12 months to November. (Eurostat said on January 7 released as estimate that showed prices in the eurozone only rose 0.8% for 2013.) Such is the concern about deflation on top of a jobless, banking and sovereign-debt crisis that the European Central Bank in November unexpectedly cut the cash rate to a fresh record low of 0.25%, in a bid to get prices to inflation at closer to its 2% target.

No one should be surprised by Europe’s slide towards deflation. It’s the logical and foreseeable consequence of the austerity and market-based reforms inflicted on bailed-out countries. The worry for investors is that deflation carries big risks for Europe if it spreads and that policymakers are split on how to stop deflation infecting more countries.

A brief spurt with deflation in peripheral countries won’t damage the eurozone, to be sure. It’s probably more likely that eurozone prices will rise at some sluggish rate in coming years, rather than tumble. Surveys show that people still expect prices to rise at an annual rate of 2% or over the next 12 months (perhaps a side benefit of all the spurious warnings about inflation). There is such a thing as “good” deflation too. Greater productivity due to technological innovations or supply shocks such as the entry of China’s cheap workforce into the world economy from 1978 can lead to benign declines in prices that raise living standards.

The deflation taking hold in bailed-out peripheral countries might not be classed as “good” as it is accompanied by crippling unemployment but the relative price adjustments has benefits. It is helping these countries regain their international competitiveness – Ireland, Portugal and Spain are now posting current-account surpluses and Greece is close to one. For within a fixed exchange-rate system, the only way current-account deficit countries can re-grasp their export edge is to engineer lower inflation rates than those prevailing in surplus countries. Since inflation in creditor countries is low, that means deflation for debtor nations. But even if there is this competitive benefit, the deflation in peripheral countries threatens to mutate into the “worst kind of deflation”, as Reserve Bank of Australia’s Glenn Stevens described this danger in 2003.² This is when a slump in domestic demand leads to a “persistent and widespread expectations of falling prices” that becomes a self-perpetuating downward spiral. Such an outcome cripples, among other victims, people and countries with excessive debts – and government debt in the eurozone has now reached 93.4% of GDP.³

Euro straightjacket

A glance at the 1930s shows how devastating deflation can be and why it is taking hold in Europe. Many economists now trace the scourge of the Great Depression to the flawed nature of the gold standard to which countries including Australia adhered. Pre-World War I, this fixed-exchange-rate regime soothed current-account imbalances by inflicting a dose of deflation on deficit countries and inflation on surplus countries – thus restoring balance among the gold-pegging countries. (A trade deficit led to gold outflows, thus a contraction in the money supply, which lowered prices, and vice versa. The rebalancing, called the “price-specie flow mechanism”, was underpinned by lending from surplus to deficit countries.)

But in the 1920s, financial distortions from the cost of the war and the fact that countries fixed their currencies to gold at inappropriate levels sabotaged this mechanism. For various reasons, surplus countries such as the US stopped recycling the lending that trade-deficit (and gold-losing) countries such as Germany needed to soothe balance-of-payments crises. Deficit countries were forced into deflationary spirals that triggered depressions to maintain their fixed exchange rates and restore competitiveness. Countries only escaped deflation by quitting the gold standard. Australia took this recovery option in 1932.

The euro is a more rigid system than the gold standard. Unlike the gold peggers, members of the eurozone lack their own currency, so can’t readily quit the exchange-rate system. Euro users lack their own monetary policy. They share a half-baked central bank, one that lacks lender-of-last-resort powers. The sole macro tool of policymakers is fiscal policy, though; through fiscal policy and other powers, they can implement reforms to regain competitiveness. That’s why policymakers felt they had little choice but to inflict a dose of austerity-induced deflation (an “internal devaluation”) to make their countries export fit again.

Bad deflation is a curse anywhere. It weakens economies as it boosts real interest rates (even if nominal rates are 0%). It prompts consumers to postpone purchases in the hope that goods will be cheaper tomorrow. The resultant slump in sales forces businesses to cut prices, which reduces their profits. Bad deflation drives up real debt burdens. Under the euro straightjacket, this combination could prove lethal for the eurozone. A deflating economy battering government revenue and forcing more spending on social security is bolstering debt-to-GDP ratios to the point of default, especially for Greece. At the end of the second quarter, this ratio stood at 169% in Greece, 130% in Italy, 131% in Portugal and 92% in Spain.⁴ The other reason why deflation is dangerous for southern Europe is that it makes it difficult to attack the jobless crisis that is sapping political stability in troubled countries.

Policy loggerheads

The deflation in peripheral countries reveals how eurozone policymaking is at cross-purposes. By cutting rates, the ECB is acting against the austerity (deflationary) policies that are making the struggling countries more competitive but which boost their likelihood of default. The central bank’s as-yet-unused pledge to buy the government bonds of troubled countries and its lending to commercial banks against junk assets are other ECB policies that hinder the competitive recalibration in southern Europe. There is no guarantee that rate cuts or unorthodox monetary policies, which could one day include quantitative easing, will help peripheral economies grow enough anyway to allow governments to get their debts under control. Their banks have too many dud loans to resume normal lending. The risk is that ECB’s steps to combat deflation will only over-inflate housing and other asset markets in creditor nations, especially in Germany.

There are solutions to preventing deflation taking hold across the bloc. But they involve the creditor nations – that is to say, Germany – agreeing to higher inflation. If Germany allowed its inflation to rise to, say, 5% then Greece could regain competitiveness with inflation of 2%. But as Germany’s inflation is 1.2%, deflation it must be for Greece. Alas for Greece and others, there is little chance of Berlin agreeing to a higher inflation target for Germans are still tormented by memories of the hyperinflation of 1921-23 – perversely forgetting how deflation and unemployment helped Adolf Hitler ascend to power. In fact, Germany is putting downward pressure on its inflation by reducing its fiscal deficit at a time when its neighbours would benefit from more domestic demand in Europe’s largest economy that expanded just 0.3% in the third quarter. Even as fiscal policy is squeezed in Germany, inflation fears triumph. Chancellor Angela Merkel told an election rally last year that the ECB “for Germany … would have actually have to raise rates” to dampen inflationary pressures.⁵

Such thinking helps explain why the two German members of the ECB’s 23-strong policy-setting board led a six-vote attempt to prevent the ECB’s rate cut in November. Influential German economists and mainstream financial media slammed the rate reduction, in what is another example of how perceived national interests being placed ahead of the eurozone’s welfare dog the continent’s future.

Frustration is growing at Berlin’s attitude against regional solutions such as a proper banking union (which would help resume lending and snip the suicide-pact between governments and banks), shared debt (eurobonds), fiscal transfers and higher inflation. The best hope for the eurozone may well be that German self-interest demands that it consider the welfare of the region, not least of all because EU members take nearly 60% of its exports. Troubled neighbours absorb rescue money and any default by a eurozone country or departure from the euro could wreak huge losses on Germany. Another hope is that Germany’s new ruling coalition between Merkel’s centre-right Christian Democrats and the leftist Social Democrats was moulded on promises to boost pensions and wages and boost fiscal spending.

The pressure on Berlin and other creditor countries to boost their economies will only grow now the deflation in southern Europe threatens to blight the eurozone. But it’s questionable whether enough pressure can be mustered against the danger of deflation to prompt an imminent solution that prioritises the welfare of the region above all.

Inflation figures come from Bloomberg and Eurostat while other financial information comes from Bloomberg unless stated otherwise.

Inflation in the 18 countries in the eurozone

Eurostat release 196/2013. “Euro area inflation up to 0.9%”. 17 December 2013. Countries ordered as done by Eurostat.
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17122013-AP/EN/2-17122013-AP-EN.PDF

1 Hellenic Statistical Authority or ELSTAT. Consumer price index. Timeseries 03. Comparisons of the overall consumer price index (2009+100.0). The main El.Stat page in English is: http://www.statistics.gr/portal/page/portal/ESYE
2 Glenn Stevens, the Deputy Governor of the Reserve Bank of Australia. Speech to the South Australian Centre for Economic Studies April 2003 Economic Briefing. 10 April 2003. Copy published in the Reserve Bank of Australia Bulletin, April 2003. http://www.rba.gov.au/publications/bulletin/2003/apr/pdf/bu-0403-3.pdf
3 Eurostat. “Euro area and EU28 government debt up to 93.4% and 86.8% of GDP.” 23 October 2013. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-23102013-AP/EN/2-23102013-AP-EN.PDF
4 Eurostat. Op. cit.
5 Reuters. “Update 1 – Merkel: ECB would have to raise rates if looking at Germany only.” 25 April 2013. http://www.reuters.com/article/2013/04/25/germany-ecb-merkel-idUSL6N0DC26720130425

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by Michael Collins, Investment Commentator at Fidelity

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Pickup in peripheral economies has contributed to a more positive general sentiment across Europe: Threadneedle

According to Threadneedle’s European equities manager Dan Ison, the traditional differentiation between the European “core” and the weaker “periphery” economies does not hold up anymore.

Economies such as Spain and Ireland performed much worse during the global financial crisis, with investment returns generally tallying this trend. However, over the past 24 months, those peripheral economies that have enacted dramatic reforms have started delivering better equity market performance compared to their “core” counterparts such as Germany and France.

Threadneedle’s European equities manager Dan Ison said:  “Last year saw a Phoenix-like resurgence in interest for European equities, with an interesting mix of winners and losers. The equity markets of Greece, Finland and Ireland performed best, while the UK, France and Italy performed worst. Germany, The Netherlands and Spain were somewhere in between. What can we glean from this? Generally speaking, those economies that have enacted the most dramatic economic reforms have delivered better equity market performance. Despite significant external pessimism about Europe’s ability for self-help, it has begun to work.

“The poster children of the Eurozone reforms are certainly Spain and Ireland. Both have exited their troika programmes. Spain can easily finance itself in open markets, and Ireland has recently conducted its first bond sale since the bailout. Unit labour costs, a good proxy for competitiveness, have fallen significantly from their peaks in both countries. Perhaps more importantly, their employment is now growing. Irish GDP saw a clear rebound, with particular strength in building and construction and investment in machinery and equipment.

“In contrast, the economies of France and Italy remain troubled. President Hollande recently conceded that France is overtaxed. Here is a socialist leader effectively calling for tax cuts and a slimming of the (very bloated) state sector. The country’s unit labour costs are flat. Italy remains a curious mix of reasonable economic data coupled with possibly the most baffling political situation in the developed world. The lack of strong government certainly hinders Italy’s ability to reform – despite being the eighth largest in the world, its economy has not grown in more than a decade.

“The pickup in peripheral economies has contributed to a more positive general sentiment across Europe. In a recent survey, Germans revealed to be more optimistic about the future now than at any time since the mid-1990s. It also leads us to believe that it is not appropriate to talk about European “periphery” vs. “core” anymore when it comes to economic growth and equity returns.

“Economies which instituted the bolder and tougher reforms are now looking towards a significant pick-up in growth compared to 2013. We expect this top-line growth to drive improved earnings in 2014, helping them to catch up with other developed markets. Our earnings forecast stands at 10% for this year.

“All in all, it looks like the European theme for 2014 will be long sangria and panettone, short sauerkraut and champagne.”

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Nikko AM maintains its preference for European and Japanese equities.

Nikko AM’s Global Investment Committee (GIC), which consists of senior investment professionals from the group’s global offices, has updated its views on the global economic situation, financial markets and asset allocation calls.

The committee meets at least quarterly and its views form the basis of Nikko AM’s quarterly asset allocation house view.

In the latest GIC meeting, the committee concluded that equity markets remain attractive and forecast that the MSCI World Total Return Index will increase 4.0% by March 2014[1]. Both the economies of the U.S. and Japan have shown strong signs of growth, while the Eurozone economy has improved significantly. In China, the economy has stabilised somewhat, while inflation remains tame.

“Nikko AM maintains its two-year overweight stance on global equities, with a preference for European and Japanese equities,” said John F. Vail, Chief Global Strategist and Chair of the Nikko AM Global Investment Committee. “In our view, Japan’s GDP in the second half of 2013 will be above consensus due to low inventories, and we expect this will provide a boost to financial markets. The consumption tax in Japan, which will be lifted to 8% from 5% next April, is likely to cause a dip in 2014 second quarter GDP, but we expect growth to recover promptly. Further evidence of strong economic growth will pave the way for additional reforms to be implemented under Abenomics.”

On the fixed income side, the house view is to continue an underweight stance on G-3 bonds, particularly underweighting Japanese Government Bonds relative to ex-Japan bonds. Targets for 10-year bonds as at March-end 2014 are 3.00% for US Treasuries, 0.85% for JGBs and 2.20% for German Bunds.

“We expect the yen to weaken further in the quarters ahead, as the Bank of Japan maintains its easing stance relative to the expected tapering measures from the Fed,” Vail said. “After the September FOMC meeting, we now expect tapering to start in December or January, QE to end in the third quarter of 2014 and the first rate hike in the second quarter of 2015. We believe the U.S. government shutdown will be short-lived and that investors would be best advised to hold onto risk positions through the turbulence. ”

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