Threadneedle: Europe – the darkest hour is just before the dawn
The European Central Bank (ECB) is embarking on quantitative easing (QE) at a time when tailwinds are already beginning to build behind the euro area economy. Threadneedle Investments’ fixed income fund manager Martin Harvey asks if we can dare to dream of a brighter 2015.
Last year, we suggested that the eurozone economy was not destined for Japanese-style deflation as long as economic momentum was maintained and the ECB stood firm. Twelve months on, and the pendulum of expectations has swung against our view, following a weak economic performance and headline inflation turning negative. We believe, however, that there are reasons to be more optimistic this year, with important implications for markets.
2014: A spiral of despair
Headline inflation continued its path lower throughout 2014, chiefly due to weakness in food and energy prices. Growth expectations were also dashed as the Ukraine crisis and ebbing global demand sapped economic momentum. It is not surprising then, that estimates for long-term potential growth have been pared significantly leading to growing fears that the eurozone economy is condemned to a long period of stagnation and deflation. Consequently, market pricing currently implies that interest rates will stay below 1% until 2023, and inflation over the long run is likely to be 1.5% rather than 2%. 10-year German government bond yields now offer a yield of 0.35%. But stepping back from the downward spiral of lower inflation and lower interest rates, we feel there are reasons to be more positive in 2015 than was the case.
2015: Curb your lack of enthusiasm
First, while inflation has been driven lower by the price of goods (largely food and energy), service price inflation has remained relatively stable, suggesting that all is not lost. Indeed, the huge fall in energy prices experienced in recent months will provide a boost to real incomes and subsequently consumption at a time when this metric is already improving. Furthermore, following the restructuring of the banking system over the past two years, the prospects for credit growth appear better, with surveys of credit demand and supply moving into positive territory. Corporate loan growth has yet to turn positive on an annualised basis, but on the current trajectory should do so in the coming months. With these dynamics, domestic demand should be well-supported in the coming year.
With respect to the external sector, the 10% depreciation of the euro over the past year should provide another tailwind. Studies have shown that exchange rate moves are a less important determinant of export growth than the strength of global demand, but nevertheless a 10% depreciation is surely more favourable than the appreciation that existed in the previous period. Furthermore, we have learned from Japan’s recent experience that a weaker currency will give a direct boost to earnings for companies that sell their products abroad, boding well for corporate profits. These domestic and external factors increase the potential for an upside surprise as we move through 2015.
The sharp fall in inflation expectations stoked sufficient fear in the minds of the ECB governing council to spark the initiation of measures that would have been unthinkable only a few months ago. The shift to negative deposit rates, the injection of liquidity via targeted repo operations (TLTROs), and the expansion of asset purchases to include government bonds (quantitative easing) will contribute to a meaningful easing of monetary policy. Given the already low level of interest rates, there is widespread scepticism regarding the effectiveness of these measures, but the aggressive change in the ECB’s stance should send a strong signal that it is serious about meeting its inflation target. The ECB balance sheet has contracted for two years, but will now be forcibly increased in a manner akin to the policies pursued in the US, UK and Japan. This is a meaningful development at a time when momentum should already be improving. We have accordingly revised up our forecast for eurozone GDP to 1.5% for 2015 from 1% previously.
Many of the current tailwinds are relatively short term in nature, whereas over the longer run structural reforms hold the key to improving potential growth in the euro area. Encouragingly, the strong outperformance of the Spanish economy over the past year is in part testament to labour market reforms enacted during the crisis. Spain is likely to perform strongly again in 2015 as domestic demand strengthens further. We are also becoming more optimistic over Italy’s prospects, where after years of economic stagnation and political stalemate, Matteo Renzi appears to be making real progress in reforming both the labour market and the electoral system. Both of these countries’ governments have some way to go to ensure long-run debt sustainability but steps in the right direction are to be welcomed.