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.

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Global threats are mounting: Fidelity

The hazards confronting the world economy are mounting. The US economy is recovering at an unspectacular pace of about 2%[1] and a sub-par labour market, sluggish wages growth, renewed doubts about the housing market and weak demand for the country‘s exports only portend more modest growth ahead.

On top of this, inflation is accelerating, the Federal Reserve is only months away from ending its asset buying and rate increases appear inevitable before too long. The defeat of House majority leader Eric Cantor in a Republican primary election in Virginia in June by a Tea Party candidate is expected to cement gridlock in Washington and could lead to more showdowns on raising the government’s debt ceiling. The eurozone is still in recession,[2] disinflation could fester into deflation, government debt loads are at default levels and banks are so crammed with dud loans they are restricting lending, while some are wobbling in Austria and have failed in Portugal. Even if European Central Bank Governor Mario Draghi’s bluff to protect the euro is soothing investors, the financial crunch in the eurozone has morphed into a political crisis revolving around a jobless emergency that is fanning support for nationalistic and fringe parties, the opposite environment needed to create the political jelling the euro needs to assure its survival. Housing is bubbling in countries from the UK to New Zealand.

The emerging world isn’t in much better shape, especially as it is riddled with conflicts. A civil war has broken out in Ukraine, only months after Moscow seized Crimea from its neighbour, and Russia could yet invade. Western sanctions against Moscow in response will damage more than Russia’s economy. In the Middle East, Syria’s civil war rages on. Islamists control much of northern Iraq and a third of Syria and the fighting pitting Shias and Sunnis could spread into other countries such as Jordan. Israel has been to war against Gaza for the third time in six years. Iran could still gain nuclear weapons. In Africa, Libya has become ungovernable. In Asia, China is creating tension, especially with Japan, as it seeks to broaden its ownership of the China Seas. Due to China’s flexing, military spending in Asia has inklings of an arms race. Nuclear-primed North Korea is as loony as ever while nuclear-armed Pakistan grows more unstable.

Financial and economic challenges are no-less menacing in the developing world. Argentina has defaulted for the second time in 13 years after a legal feud with “vulture funds”, an outcome that will damage South America’s second-largest economy. China’s property market is deflating, while Beijing is only making half-hearted attempts to police out-of-control lending because it worries that proper regulation might make the country miss its 7.5% growth target. So challenged are many emerging countries by current-account deficits, inflation, sluggish economic growth and plunging currencies that labels of the past such as BRICs that flagged the potential of developing nations have given way to “fragile” plus a number; i.e., the “fragile five” are Brazil, India, Indonesia, Turkey and South Africa.

Could any of these challenges morph into a shock as damaging as the collapse of Lehman Brothers in 2008? Or could some other threat not yet evident emerge? Maybe it will be a jump in interest rates. Some analysts say it’s only a matter of time before Saudi Arabia is engulfed in the political turmoil of its neighbours. Just think what that would do to oil prices. Whatever form any shock could take, if one should occur, it’s not so much the shock that should worry investors. It’s the powerlessness of authorities to respond. There is, however, one hope that shines out from the events of recent years.

It must be said that there are always dangers to the global outlook and most of them are overhyped and fizzle out. So most likely will today’s perils. Since World War II, global politics has been far more volatile than today, even when the nuclear armed superpowers confronted each other as during the Cuban missile crisis in 1962 or the Yom Kippur War of 1973 that led to the first oil price shock of the 1970s. Even amid all the current hazards, the World Bank still expects the global economy to expand this year, even if that expected pace of growth for 2014 was reduced to 2.8% in June from the 3.2% forecast the bank made in January.[3] Other good news is that inflation is only a menace in a few countries. Japan’s radical economic experiment is going well so far. In India, the dominant election victory of BJP has sparked hopes the government can enact reforms that will rejuvenate the world’s second-most-populous country. Indonesia, the world’s biggest Muslim country that only 15 years ago was an economic and political basket case, is expected to advance further under new president Joko Widodo. US banks are better capitalised and are under tougher regulation. Across the globe, current accounts are better balanced, thus removing the savings mismatch that was a key cause of the global financial crisis of 2007-08. Any shock these days would have to be huge to outdo the jolt to consumer and business confidence that was inflicted by the collapse of Lehman Brothers, most likely a once-in-a-generation event, for people are hardened to alarms nowadays. Even allowing for all this, though, the world appears more precariously placed to cope in the unlikely event of a shock than it was six years ago.

All together now

When the US sub-prime crisis morphed into a global financial crisis in September 2008 policymakers in affected countries responded almost in unison. Central bankers slashed interest rates. They provided emergency funding to banks. Those in the US and the UK embarked on unprecedented asset buying or quantitative easing, a cure invented by the Bank of Japan in 2001. Political rulers provided massive fiscal stimulus. They nationalised banks. They guaranteed bank deposits even, mistakenly in Ireland’s case, backed bank debt.

These steps succeeded in avoiding another Great Depression, a feat in itself, but some harm was unavoidable and unintended consequences arose. The resulting Great Recession ushered in double-digit jobless rates while low interest rates fanned housing and other asset bubbles around the world. Policymakers made mistakes too. Austerity policies implemented in Europe and elsewhere have hobbled economies, boosted the ranks of the jobless and worsened government debt levels. The ECB could well turn to asset buying too late to stave off deflation.

These side effects and errors could add to the severity of the next downturn in the unlikely event of a shock. The greater problem, though, is that if another jolt comes authorities are much more handicapped than they were six years ago. Most of the steps that supported economies and banking systems in 2008-09 have lost their muscle. Major central banks already have reduced cash rates to record lows, so on this score they are immobilised. Quantitative easing has been unmasked as no miracle cure, even if it can help avoid a catastrophe or deflation. Research in 2012 out of John Hopkins University found that any reduction in interest rates from asset-buying programs was fleeting and “quite modest”.[4] While other studies might be kinder to central-bank asset purchases, it’s hard to believe that the Fed would do much for the economy if , say, it restored its monthly asset buying to US$85 billion again to limit shockwaves. Such a policy retreat might even deal another blow to confidence for the Fed and other key central banks have swelled their balance sheets to levels that approach the limits of investor tolerance, or at least to levels that provide fodder for scaremongers. The new (old) world of macroprudential controls, or financial regulation, to fight asset bubbles is fraught because it injects central bankers into the centre of political decisions.

Politicians and the executives they control appear just as toothless. Many governments are so debt laden they would be challenged to pursue the fiscal stimulus matching that of 2008 to 2010. Net debt sits at 74% of GDP for advanced economies, about where the average stands for the 18-member eurozone.[5] The US government net debt has reached 82% of output, while Japan’s ratio has soared to 137%. The straightjacket that such ratios put on governments is shown by events in Japan. Fiscal pressures forced Tokyo to raise the sales tax by three percentage points in April this year, a move that acts against the consumer spending that propels the economy, thus jeopardising the gains won so from the radical monetary experiment to engender inflation and economic growth. The US debt pile is the defining restriction on Washington’s ability to stimulate the US economy, which post-2008 was helped by annual fiscal deficits averaging 9.2% of GDP from 2009 to 2011.[6] The fight over US government finances has already produced the brinkmanship over the so-called fiscal cliff and two debt-ceiling showdowns that took the country to the brink of default. Perhaps more worrying, austerity advocates are winning the political battle in countries where government debt is low. There would be few better examples than Australia, which promoters of smaller government claim is facing a budget emergency (rather than just a persistent gap between outlays and revenue) when net government debt is all of 16% of GDP. Consumers won’t be able to rescue economies either. Households are still burdened with near record debts as a percentage of GDP and, come a shock, will own plunging housing assets.

What hope then for the world if a thunderbolt materialises? Most likely this. Policymakers the developed world over know they are at the limits of their power. They must have thought of possible remedies if something bad happens. If not, they have proved they can whip up palliatives if economies and banking systems shudder. The years after the global financial crisis struck ushered in unprecedented amounts of quantitative easing and emergency lending to banks under central-bank lender-of-last-resort facilities and massive fiscal stimulus. The era produced soothers such as zero interest rates and the invention of negative interest rates, which Sweden introduced in 2009 followed by Denmark in 2012 and the ECB this year. Central banks entered into bilateral currency swaps with the Fed to ensure enough US dollars to support banks in their spheres. Other central-bank tonics were so-called forward guidance to soothe any concerns about rate increases, ECB repurchase agreements designed to shove massive amounts of money at banks, Fed purchases of mortgage-backed securities to help revive housing, Fed lending facilities for borrowers and investors in crucial credit markets and cunning bluffs such as timely pledges by policymakers to do “whatever it takes” to save this and that, as the ECB did for the euro. These cures may not be enough if strife hits again but they give hope that policymakers have the inventiveness to limit the damage in the unlikely event that a threat materialises.

Financial information comes from Bloomberg unless stated otherwise.

 by Michael Collins, Investment Commentator at Fidelity

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