Rising deflation risks in the Eurozone

I argued in November (see: No inflation pressures in the Eurozone) that inflation fears for the Eurozone are unfounded and rather deflationary risks in the periphery are significant. In the meantime headline and core inflation rates have fallen below the 2% target level. However, inflation pressures have continued to ease and inflation rates should be expected to fall markedly further to below 1% during summer.

The chart below shows the development of various inflation measures for the Eurozone. Headline and core inflation are well known. However, I also calculated a core measure ex administered goods and services. The price changes for administered goods & services are to a large extent directed by the sovereigns and amid the massive fiscal tightening in a large number of countries there has been significant upward pressure on the administered goods prices. Furthermore, I try to deduct also the effects of changes of consumption taxes on prices (Eurostat publishes a constant tax rate HICP). The green line shows this adjusted core inflation measure (i.e. a measure of inflation stripped off the effects of energy&food prices as well as the direct impact of fiscal tightening). This inflation measure stood at 0.4% in January. At that time, core inflation was at 1.3%. Hence, two-thirds of core inflation stemmed from higher prices for administered goods & services as well as higher consumption taxes. On a country level Spain is in outright deflation and France is at 0% inflation according to this measure.

Inflation developments in the Eurozone 

Source: Eurostat, ResearchAhead

Looking ahead, price pressures should ease markedly further. First, as headline inflation has been running above the core measures, prices for food & energy continued to exert upward pressure on inflation. However, as the chart below shows, Brent crude oil in Euros has already dropped by approx. 15% since early February and from where they stood a year ago. This is the largest yoy drop in oil prices since 2009 (i.e. at the height of the global financial crisis). Following a spike of approx. 40% last summer, also food prices (measured by the S&P GSCI Agriculture Index in Euros) have now turned negative on a yoy basis. As a result, the inflationary impact of food&energy prices should wane over the next months and headline inflation should fall to (and might even undershoot) the core inflation rate.

Year-over-year %-change of Brent crude oil in Euros

Source: Bloomberg

However, besides easing headline pressures, also core inflation rates should continue to fall further. For one, unused capacity in the Eurozone is at extremely high levels. Moreover, monetary developments remain very weak and M3 grew by only 3.1% yoy in February with the 6m annualised increase only at 2.1%. Within M3, M1 continues to be the main driver for M3 growth, while the broader aggregates continue to shrink. The 6m annualised change in M3-M2 has collapsed to -20% in February! As the chart below shows, growth in M3-M2 is a good leading indicator for core inflation and suggests that inflation pressures have been easing further. On the other side, credit growth remains very weak also, falling by 1.2% yoy in February. In Spain, loans for corporates are collapsing by almost 20% yoy and to households by 5%. But also in Italy, loan growth is negative while in Germany it stands at only 0% for corporates and 1% for households.

Growth in M3-M2 suggests easing core inflation pressures

Source: Eurostat, ResearchAhead

As a result, the combination of weaker energy and food prices on a year-over-year basis as well as very high unused capacity and very weak money and loan growth all suggest that core and headline inflation rates should fall markedly over the next few months. Sub 1% inflation rates during summer are very likely and should raise deflation fears. 

Investing along national lines should continue to pay off

I have a new blog written in German which focuses on developments in the German economy as well as German economic policy matters: http://tanzueberdemabgrund.wordpress.com/.

I have been convinced that the multi-year outlook for various developed market economies is very different and accordingly investing along national lines should pay off. This has been the case ever since the financial crisis broke out and country views should continue to guide investment decisions for the next few years.  

Germany: I have been looking for Germany to outperform for quite some time (see for example: There is more to celebrate for Germany dated Nov 10, 2009). Germany enjoys an easy monetary environment amid record low real yields and a relatively high credit availability. Furthermore, at current exchange rate levels, German corporates can continue to gain market share. The fiscal deficit poses no threat and amid ongoing growth, sovereign debt levels can fall. Hence, no fiscal tightening is necessary. Additionally, some of the factors which held growth back since the mid 90s have disappeared or reversed (most notably a large drop in public sector employment, a sharp  drop in construction activity and declining immigration). Public sector employment has been stabilising, construction has been growing again and immigration is on the rise. These factors mean that while average/trend growth was depressed between 1995-2009, it can increase again. Risks for the German economy stem mainly from the political side. Following the elections in autumn this year, the political landscape might change towards a less economy friendly environment (higher taxes, more regulation).

Austria & Belgium: The financial crisis/ Eurozone sovereign crisis has burdened Austria & Belgium especially via their banking sectors. However, the stabilisation in Eastern Europe, the liquidity provision measures by the ECB, most notably the 3y LTROs, and the systemic backdrop provided by the OMTs and the ESM have significantly reduced the banking woes in these countries. Furthermore, fiscal deficits do not pose a threat as the primary balance is close to 0% in both cases. With the help of the very low sovereign bond yields, fiscal deficits should remain under control with no further savings measures necessary and debt-GDP ratios should be able to shrink over the medium term. Hence, Austria and Belgium profit from an easy monetary and neutral fiscal environment and do not suffer from significant structural problems. Their sovereign bonds should do relatively well vs. the rest of the semi-core markets over the longer term.

However, there is a large group of Eurozone countries which faces a difficult longer-term environment. Greece, Portugal and Spain continue to face adjustment recessions to restore competitiveness and reduce fiscal deficits which will restrain growth. But also Italy, France and the Netherlands find themselves in a difficult position. Italy and France need to restore competitiveness of their industrial sector and both economies suffer from very rigid labour markets. In the case of Italy, political uncertainty has been rising amid the election gridlock. As Italy has a large primary surplus, it does not need more fiscal austerity. Rather structural reforms are needed to restore competitiveness and increase trend growth. France, on the other side, needs more fiscal savings measure to bring back the deficit and stabilise debt-GDP ratios. The combination of a lack of competitiveness for the private sector coupled with significant and ongoing austerity measures will depress French growth for quite some time. In the case of the Netherlands, the private sector is over-indebted. Given that unemployment has risen from 5% in mid 2011 to 7,5% in January this year and as the housing market has entered a correction (house prices are down by 9,6% yoy in January), consumer spending should be weak going forward and also hold back business investment. Furthermore, the state needs to lower its fiscal deficit which will only aggravate the cyclical downturn. The short-term outlook for Greece Portugal, Spain, France and the Netherlands is for weak growth, the longer-term outlook remains most challenging for France (as so far they have not done anything to restore competitiveness). In the case of Italy, the situation is uncertain. Amid the political gridlock, political and hence economic uncertainty is rising. This should have a negative effect on business investment and households' consumption of durable goods. On the other side, should a relatively stable government be formed, then Italy could move back to low but positive growth. Most likely such a new government will not be able to drive through more austerity measures (which are not necessary anyhow) and significant structural reforms (which would be necessary). The net effect would be that Italy should be able to move back to a low but positive growth environment over the course of this year.

Elsewhere in Europe, I have been bearish on the UK economy for a long time (see for example: Revisiting the UK: not much good news dated August 18, 2009 ). The UK is suffering from the weakness in the financial sector where its economy is highly exposed. Furthermore, the UK’s oil sector output has dropped by approx. a quarter over the past four years and is in steady decline. Aggravated by the government’s savings measures, the economy has been failing to grow. Furthermore, while the trade-weighted GBP has dropped by approx. 20% since before the financial crisis, this was not mirrored by an improvement in the current account. Rather to the contrary, the current account deficit is larger than before the crisis and the weaker GBP was mostly reflected in higher inflation. A further easing in the monetary environment will only result in another weakening of GBP and in the end, the BoE will be almost the only net-buyer of Gilts. Ultimately, the BoE will be holding these Gilts forever (or cancel them with the Treasury). Hence, the money created by the quantitative easing measures should be seen as a permanent increase in base money and is unlikely to be absorbed again.

In the US, the situation is very different. While the fiscal deficit is relatively high and the Fed continues to conduct QE as well, the situation of the economy is much more favourable. The economy has recovered the lost output from the financial crisis. A key driver might be the increasing oil & gas output which also puts significant downward pressure on the current account deficit. Furthermore, the housing market has turned the corner. If the politicians don’t overdo it with fiscal tightening, then the economy should soon find its way back into a higher growth environment which then will also depress the deficit. Hence, I am optimistic with respect to medium-term outlook for the US economy (though in the near-term, economic data might disappoint amid the fiscal tightening).

Economies & Markets in 2013

This is a shortened version of my macro and markets outlook for 2013 

The so-called developed economies remain in a low nominal growth environment where the private sector deleveraging and the over-indebtedness of the public sector act as structural growth headwinds. Historically, the public sector successfully deleveraged via default or via a long-lasting combination of relatively tight fiscal policy (to slowly move to a primary surplus) with an ultra-loose monetary policy (to get low/negative real yields, accompanied by other elements of financial repression). Between 2010 to late 2011 the handling of the Eurozone debt crisis (ultra-tight fiscal policy & limited support from monetary policy, Greek PSI) increased the probability of the default option and hence meant high and rising systemic risks. However, in 2012 governments and more importantly the ECB changed the trajectory via the introduction of OMTs (whereby the ECB has assumed the lender-of-last-resort role for governments), the start of the ESM and steps towards a banking union as well as a weakening political support for ever more fiscal austerity. In turn, the Eurozone has been moving towards the second option for debt reduction, substantially reducing systemic risks.

Moreover, also policy makers in the UK and US have been moving towards a tighter fiscal but looser monetary policy stance. Finally, following two years of ever weakening growth, the global economy is in a bottoming process and real growth should increase moderately going forward, lead by an improvement in Asia ex Japan. On the other side, amid the ongoing deleveraging and the high level of unused capacity, inflation pressures in general remain low and hence nominal growth should remain low as well. 

Eurozone real growth should slowly bottom out and move slightly above 1% in H2 2013. Germany should lead the rebound on the back of increased export demand and as record low real rates as well as rising immigration support the domestic economy. Moreover, Italy might be surprising with a growth pick-up. On the other side, due to the ongoing substantial fiscal tightening, France and Spain should lag in this recovery. Overall, the necessary rebalancing of the Eurozone economies should take a major step forward.  While real growth should improve, inflation pressures will drop further. Roughly half of the current core inflation rate of 1.4% stems from the effects of the restrictive fiscal environment. As the impact of fiscal tightening slowly wears off, inflation rates should fall. Furthermore, excess capacity remains at very high levels, preventing inflation from rising even if growth improves. As a result, nominal growth will remain low for a long time. 
Global real growth is in a bottoming process and should improve gradually during 2013. The outlook for inflation is mixed, with falling inflation pressures in the Eurozone and gradually rising core inflation pressures in the US while Japanese deflation can abate if the BOJ goes down the proposed policy route. Furthermore, systemic risks should remain at the now lower levels. This is an environment where risk appetite can improve, safe-haven assets should come increasingly under pressure, assets linked to real growth will be supported but assets linked to inflation should face a mixed outlook. Importantly, it will mainly be the safe-haven currencies central banks (BOJ & FED, BOE) which will provide an increasing dose of monetary accommodation. This should undermine the safe-haven status of their currencies exactly at a time where risk appetite improves.

Sell safe-havens, buy pick-up & real growth assets and take a mixed approach on inflation:

• Long carry products with a focus on steep curve areas. Move outright longs in higher-yielding semi-cores into spread trades vs. Bunds. Outright longs in peripheral bonds and spread tighteners vs. Bunds across the curve. Start the year with Bund shorts spread trades and add outright shorts as the year progresses.
• Short safe-haven currencies (JPY, USD, GBP). Long growth currencies & Euro.
• Outright shorts in safe-haven bonds, mostly from safe-haven currencies - i.e. USTs, JGBs - but also to a lesser extent Bunds.
• Safe-haven curve steepeners & credit curve flatteners.
• Short inflation protection in the Eurozone vs. long inflation protection in the US & Japan.

Low systemic risks & low nominal growth

I have published a short presentation "Low systemic risks & low nominal growth". This is a brief update to my strategy presentation from August "Life in a negative real yield environment".

 

There are three key points I want to make which I think so far have gone underrepresented:

1. Inflation pressures in the Eurozone are highly overstated. I adjust the Eurozone inflation figures for the effects of restrictive fiscal policy (via higher prices for administered goods and higher taxes on consumer goods). This adjusted core measure runs only at around 0.5% yoy! Hence inflation for the private domestic economy is almost non-existing. I think this is so far not really recognized but should come as no surprise given the high level of unused capacity/record high unemployment and the subdued development of monetary aggregates and loan growth (loans to non-financial corporates have been falling by 1.8% in October yoy). As "true" inflation is lower, "true" real yields are somewhat higher than those traded in the market (which also focus on HICP) and hence the safety premia inherent in Bunds is lower. I do expect Bund yields to rise over the medium term as real growth improves and the stress in peripheral bond markets eases, however, nominal growth will remain subdued and hence upward potential for 10y Bunds is limited (I expect 1.75% 6m).

2. Markets have shifted their trading behaviour. Ever since the financial crisis broke out, RORO (risk-on, risk-off) dominated market developments. Equities, credit spreads, volatility, commodities, growth currencies have all moved in sync and opposite to safe-haven assets (Bunds, UST, JPY, USD). RORO was dominated by changing perceptions of systemic risks (which then drove also the expectations for growth and inflation). Now, however, systemic risks have been dropping significantly (as the ECB has turned itself into the lender-of-last resort for sovereigns) and RORO has given way to GOGO (growth-on vs. growth-off). In this environment it is changes for nominal growth which drives market performance while systemic risks remain low. In turn, equities, commodities and growth currencies move in sync while credit spreads and volatility remain low even during periods where the other markets correct.

3. In an environment of limited volatility and anchored short end rates (as central bank target rates remain unchanged), so-called Horizon Returns gain in importance as a tool to direct investment/as a relative value tool. It is not only carry that is important but also roll-down on the yield curves. Horizon Returns measure both.

My investment views remain unchanged: Systemic risks remain low favouring carry products. The long-term trend towards lower nominal yields on safe products is over (i.e. Bund yields most likely have hit bottom) but upside potential on safe yields is moderate in the short term. The long-term trend towards lower nominal yields on carry products is not over (and hence semi-core/peripheral bonds have more potential). The global growth cycle should have bottomed with Asia ex Japan improving and the slow improvement of the US economy only being temporarily interrupted by the fiscal cliff. Growth currencies should be bought and safe-haven currencies should be sold on uptics (with the Euro being between these two groups).

No inflation pressures in the Eurozone

Amid the zero rate policy of the ECB, its significant balance sheet lengthening with the help of the 3y LTROs as well as the introduction of Outright Monetary Transactions (should a country apply for help of the ESM) some commentators (especially in Germany) fear that the ECB has become too tolerant of higher inflation and see inflation pressures as being just around the corner. Currently, Eurozone headline HICP stands at 2.6% yoy and core inflation at 1.5%. Amid the weak state of the economy this would at first sight confirm that inflation might become a serious issue once growth starts to recover. However, this is largely due to tighter fiscal policy and as I will show below domestic inflation pressures in the core countries are limited and the periphery is even flirting with deflation. Given that at present private sector loans in the Eurozone are collapsing (the annual growth rate of loans to non-financial corporations stood at -1.4% in September, down from -0,7% in August) and unused capacity is substantial, domestically generated inflation does not promise to become too high within the next few years even with a zero rate policy by the ECB for much longer.

The chart below shows the development of various Eurozone HICP inflation measures. Headline HICP is currently running above target (blue) while core HICP (black) of 1.5% is close to the ECB's target of "close to but below 2%". However, amid the widespread fiscal tightening - especially in the periphery - prices for administered goods and services as well as taxes such as VAT have gone up and hence have a strong impact on current inflation rates. I calculate a core HICP measure excluding administered prices (red) which is currently running at only 1.0% (just one caveat: the basket of administered goods and services as well as the basket of energy and food might partially overlap and hence it is not a perfect measure but just an estimate). Hence, 0.5% of current inflation is due to changes in prices of administered goods and services. Furthermore, I used Eurostats constant taxes inflation measures to also deduct tax changes from the inflation rates. This core HICP CT ex admin prices inflation rate currently stands at only 0.7% (green, this series is only available with a one-month delay). Hence, another 0.3% of current inflation are due to tax changes.
As a result, at present approx. 0.8% out of the 1.5% core inflation rate are due to fiscal tightening! The real domestic inflation rate currently stands at a much lower 0.7% and does not show any meaningful risk of rising inflation pressures. Clearly, the ECB should c.p. rather ease monetary policy in an environment of tighter fiscal policy even if the tighter fiscal policy temporarily leads to a higher measured HICP.

Eurozone inflation rates

Source: Eurostat, ResearchAhead

In the chart below I show the core HICP measures for the four largest Eurozone countries (Germany, France, Italy and Spain). Looking at this measure one would conclude that inflation rates are close to each other and close to target. Furthermore, Spanish inflation has risen significantly over the past months.

Country core HICP

Source: Eurostat

However, looking at the core HICP CT ex admin prices for these countries leads to very different conclusions: A) inflation rates between the core and the periphery have started to diverge significantly (this should be seen as a positive factor as it helps the Eurozone to rebalance). B) Spain and to a lesser extent Italy are flirting with deflation.

Country core HICP CT ex admin prices

Source: Eurostat, ResearchAhead

Overall, inflation pressures in the Eurozone are low. However, the risks of deflation in the periphery are significant. In this environment, the ECB can conduct more monetary easing without threatening price stability. Amid the high level of unused capacity, significant fiscal tightening and very restrictive monetary environment in the periphery (high level of real yields, low credit availability) a renationalisation of monetary policy seems very sensible. The sooner the ECB eases the monetary environment in the peripheral countries (for example via buying peripheral debt), the better.