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Stephanie Flanders: Understanding the risk of deflation in Europe

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The eurozone is in recovery mode at last. But there are a number of risks and potential headwinds that could blow this fragile improvement off course and pose challenges to investors.

These include:

  • Renewed stress in financial markets and concern about the strength of the banking system, possibly in response to the ECB’s ongoing review of the quality of assets on bank balance sheets
  • A larger-than-expected slowdown or sustained bout of financial volatility in emerging market economies, which account for a larger share of European exports and corporate profits than the US
  • The possibility that low and falling rates of inflation will tip large parts of the single currency area into outright deflation.

Of these, the risk of deflation is possibly the most serious and the steady decline in the eurozone inflation rate in 2013 has made this a live issue, as shown above.

We have seen widespread disinflation – falling inflation rates – in the eurozone in the past year but only Greece has seen a prolonged period of deflation –  a fall in the average price level itself. That is an important distinction.

Disinflationary periods can be healthy for companies and the equity market, especially if they improve relative rates of competitiveness. But sustained, economy-wide declines in prices – true deflation – is another matter. The risk is that a deflationary psychology can take hold as consumers and businesses defer purchases and investments in anticipation of further declines in prices.

Learning from Japan

As Japan has shown, full-blown deflation is particularly debilitating in countries with high levels of public or private debt. There is a real risk in these circumstances of the economy going into a deflationary spiral as households and companies struggle to get on top of debt burdens that are rising in real terms.

Latest figure for February shows the headline measure of eurozone consumer price inflation at 0.7 per cent. That is close to the lowest rate recorded since the single currency was launched and closer to zero than the central bank ought to find comfortable, given its target of infla-tion “below but close to 2 per cent.”  

A prolonged period of Japan-style debt deflation would be deeply damaging to the region’s recovery and potentially pose serious risks to global growth as well. Even a moderate risk of this outcome ought to — and probably will — trigger further action by the ECB.

Stephanie_Flanders_table_April3

However, that kind of damaging deflation is not the only kind of deflation there is. Deep structural reforms on the scale currently being undertaken by crisis economies such as Spain and Portugal can also be associated with falling prices as countries are forced to squeeze prices and wages to restore competitiveness.

Ireland offers a recent example of a eurozone economy suffering a fairly significant period of falling prices without plunging into a Japan-style decline. Ireland’s core price index fell by 4 per cent between 2008 and 2011, before moving back into positive territory in 2012.

For Ireland, a transitory period of falling prices appears to have been beneficial in helping it achieve a rapid improvement in its competitiveness.

Optimists say the same could be true for other periphery economies and point to the fact that economic activity and consumer confidence have been rising in the eurozone, even as market expectations of inflation have been going down.

But even if the region avoids Japan-style deflation, it is worth noting the relatively low level of inflation in the eurozone has already made a big difference to its nominal rate of growth relative to other regions. In cash terms, the eurozone economy was 7.9 per cent larger in the third quarter of 2013 than at the start of 2007. This compares with nominal GDP growth of 20 per cent in the US and 17.6 per cent in the UK. The contrast with the UK is especially striking, given that the UK has not grown faster than the eurozone in real terms over this period. A higher rate of inflation has made it easier for the UK to work through its debt problems.

Summary and investment implications

One message is clear – ECB policy will remain exceedingly loose in 2014. Even if the ECB does not take additional action, chances are that it will do something if there is any further fall in inflation.

We expect Europe to do much better in 2014 than it did in either 2013 or 2012 but the fear of deflation poses a risk to that scenario, even if the fear does not materialise.

The binary nature of the deflation risk makes things tricky for inves-tors. Very low rates of inflation can be good for equities and other real assets, especially if it keeps monetary policy easy for longer. But the moment the situation tips into outright deflation, equities would be likely to suffer.

We believe there are opportunities for equity investors in our base-case scenario – that the eurozone will continue to build economic momentum in 2014 and avoid deflation. That points in favour of a continued overweight in risk assets.

However, in the context of a well diversified portfolio, the downside risks associated with low or falling inflation suggest a somewhat more conservative allocation of equities, relative to fixed income, than if deflation were less of a concern.

Stephanie Flanders is chief market strategist, UK & Europe, at J.P. Morgan Asset Management

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