Managing the risk of eurozone deflation
Lower nominal growth and uncertainty would depress the value of many financial assets and raise risk premiums if deflation were to take hold in the eurozone – but some assets would still be shielded from its negative impacts, according to Valentijn van Nieuwenhuijzen (pictured), head of Multi Asset at ING Investment Management.
ING IM’s base case scenario is that deflation will not occur in Europe. But with many investors talking about the ‘Japanification’ of the eurozone, ING Investment Management has assessed the impact on various assets if those fears were to materialise. “Europe remains more likely than not to escape deflation. However, it is clear that the fight against deflation and the fear for it is not yet won. Given the low level of interest rates and higher risk premiums currently prevailing in Europe it seems that even without actual deflation a substantial part of this a deflation scenario is already priced by markets.”
Deflation would depress nominal revenue and earnings growth and therefore lower equity valuations. However, companies with high international exposure, low financial and operational leverage and strong market positions would probably still do well: for example, luxury goods companies with their high margins, price insensitivity and international exposure would outstrip low-margin mass retailers with no pricing power and domestic exposure. Technology companies should still prosper too due to their short product cycles, constant innovation and the strong balance sheets currently typical of the sector.
In bond markets, both the real yield and the inflation premium would be low under deflation, implying a low or negative real yield. The nominal German Bund yield, for example, would approach 0% and the longer deflation lasts, the more very long maturities would trend towards zero. Credit spreads and defaults would rise substantially, especially from the current low levels as weaker companies would struggle the most in a sluggish economy. High Yield (HY) paper would likely fall more than Investment Grade (IG) with HY spreads rising disproportionally more on a risk-adjusted basis.
Therefore, central banks have to react in the early phase as market expectations can, to a considerable extent, create their own reality: this is a real danger, even more so because deflation in an early phase is not easy to identify and actual deflation is a costly phenomenon.”
Given Europe is the main export region for Emerging Markets, EM assets would also likely to suffer if deflation were to afflict Europe. But assuming forceful action by central banks, a resulting search for yield would boost demand for EM debt, especially if denominated in hard currency (USD), which would be supported by stronger global liquidity conditions. EM debt would be preferable to EM equities, as the expectations for global liquidity and capital flows to the emerging world would benefit, but EM growth would be negatively impacted. EM currencies that are linked to the euro bloc (e.g. the zloty, forint, the koruna) would underperform the universe that is primarily linked to the US dollar.
The euro would most likely weaken if the eurozone were to slip into deflation. However, it would probably only start to weaken meaningfully if the European Central Bank announces an aggressive sovereign QE program. Actually, the latter might even happen without deflation as sovereign QE is our base-case outlook for Q1’15.
In a deflationary environment, the private sector gets stuck in a cycle of depressed inflationary expectations and monetary policy is not forceful enough to guide these expectations back toward the central bank’s inflation target. Seen from this angle, the deflation risks in euroland are certainly substantial as low-flation and a large output gap are pulling down inflation expectations and the imbalanced nature of the economy presents additional difficulties. However, the policy response in terms of steps towards banking union and monetary policy actions, are hopeful: we strongly believe that the latter will ultimately determine which way inflation goes.