Euro area: deflation is looming

For investors, in a context of deflation, caution calls to focus on good balance sheets (sovereign as well as private) and to concentrate in companies able to grasp growth where it is, such as companies exporting in fast growing markets.

According to Eurostat’s flash estimate, euro area annual inflation is expected to be 1.2% in April, down from 1.7% in March and well below consensus expectations of 1.6% y-o-y. It is the largest monthly fall since May 2009 and also the lowest level since February 2010. Moreover, the euro area’s core annual inflation (inflation excluding energy, food, alcohol & tobacco) is expected to drop by 0.5pp to 1.0% y-o-y in April.

Fall across the board

Looking at the main components of euro area inflation, the decline was driven in large part by an on-going collapse in energy prices (-0.4 % y-o-y in April from 1.7% y-o-y in March) despite a rather stable price of oil in euros. It is worth recalling that energy prices were just above 9% y-o-y last September! But energy prices are not the only culprit, as core prices also collapsed in April from 1.5% y-o-y to 1.0%. There was a lot of volatility recently. Based on fundamentals, April’s figure appears as an outlier but beyond short-term volatility, it is clear that the current context made of recession, austerity, a strong euro, high unemployment and low demand creates the conditions for a deflationary scenario.

A policy geared towards deflation

The policy pursued so far in the euro area to solve the crisis has been to restore competitiveness in the periphery countries through a favourable inflation differential (i.e. lower inflation in the periphery than in trading partners). Fiscal austerity and pressure on wages have dampened inflation in these countries. But in the meantime, the core countries were supposed to inflate gently, in order to amplify the effect. Unfortunately, the deflationary policy conducted all across the board has even pushed Germany into an impressive disinflationary process. As a result, inflation in periphery and core countries has converged to a very low level. In April, it stands at 1.2% in Germany and Italy, and 1.4% in Spain. So the gain for the periphery countries are limited and this process, if pursued, will lead the continent to deflation. This is the worst outcome for over-indebted countries as deflation pushes the debt-to-GDP ratio higher and makes debt servicing unaffordable.

Inflation break-even pointing South

Markets have been anticipating this risk for a while. But with today’s news the risk of seeing the euro area fall into a Japanese scenario (before Mr Abe’s recent decision to implement QE) has significantly increased. For investors, in a context of deflation, caution calls to focus on good balance sheets (sovereign as well as private) and to concentrate in companies able to grasp growth where it is, such as companies exporting in fast growing markets.

Risk of deflation will make the ECB’s action easier

The only positive aspect of this development is that it will give the ECB some room to manoeuvre. As the German economy is also impacted by economic slowdown and disinflation, the Bundesbank will be in a weaker position to oppose monetary policy relaxation and new non-standard measures to be adopted.

So these developments reinforce the case for a 25bp rate cut on Thursday. On the other hand, it is probably too early to see non-orthodox measures being announced this week. We continue to expect that something bold has to be done notably in order to favour credit for SMEs, but the ECB’s Board probably needs more time to convince all parties involved.

Even if taken swiftly, the ECB’s measures will take time to deploy all their effects. So our inflation forecast is revised down for both 2013 and 2014.

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