Eurozone closer to Japan than US, UK on inflation risk

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Looking globally, I believe the eurozone has more in common with Japan than with the United States or the UK at this point, and I think that trend will likely continue.

Inflation in the eurozone is running at 0.4%, which is a far cry from the ECB’s 2% target. My team and I expect inflation will likely rise a little next year, but it’s likely not going anywhere near 2%. I think that’s what ECB President Mario Draghi is primarily concerned about. He has said the ECB is fully behind undertaking whatever measures are necessary to combat low inflation.

I expect the Bank of Japan (BOJ) and the ECB should likely continue to be accommodative to combat deflation and low inflation in their respective countries. Much has been made about the amount of liquidity the US Federal Reserve Bank (Fed) has pumped into the US economy during its quantitative easing (QE) programme. But, when you take into account what Japan and Europe combined are currently contributing to their QE programmes, it probably more than matches what the United States was doing. So, on a global scale, we have probably just as much or more liquidity being created now than when the Fed was acting alone.

Meanwhile, the US economy has been performing relatively well. In the United States, the Fed has indicated it is going to stop its QE programme this month, and its next focus will be on when to raise interest rates. That’s a strong differential to make, and it has ramifications for the currencies. We think the euro should probably weaken against the US dollar and, to a lesser extent, the British pound—it has already weakened quite a bit against the pound—because the economies are on different trajectories. That might suggest to investors that European bonds may be a good place to look for potential opportunities. In our portfolio, we have taken a long-duration posture in Europe.

 

David Zahn is head of European Fixed Income at Franklin Templeton

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