EU Economic Update – 28 October 2014

European inflation data represents a further risk to markets

While US monetary policy and growth data are likely to take centre stage this week, there other items on the agenda which have the power to disrupt markets. These come in the form of German CPI and Flash euro-zone CPI figures for the month of October.

Official projections suggest that the German economy will have entered into a deflationary environment during the period, after several months of flirting with nil inflation at 0.0% price growth for the months of August and September.

In addition to a dire outlook for German inflation, the bloc wide Flash CPI measure is also expected to highlight subdued price pressures across the EU as a whole.

While a minor bounce is expected from 0.3% to 0.4% for the current month, this will do little to placate concerns that the currency bloc is heading for the rocks, after several years of persistent, but staggered, declines in price pressures that are yet to show signs of running out of steam.

As such, there is little doubt left in the minds of many observers that Europe is now heading at a rate on knots into the type of deflationary malaise that has gripped Japan for the last two and a half decades.

All in all, with recent inflation data taken into account, the outlook for the bloc as a whole appears to be deteriorating.

While there have, and continue to be, pockets of progress on the periphery; this will not be enough to prop up investor sentiment toward the currency union if the economies at the core of Europe continue to show signs of heading to the wall.

Should this fragile sentiment toward the bloc deteriorate further, then the consequences could be wide and far reaching with very few investors immune from the fall out. 

With this in mind, the most important question on the lips of investors at present is what will the ECB do about something that many now describe as a crisis in the making?

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The ECB and Quantitative Easing

From current rhetoric we can infer that the European Central Bank remains convinced that the outright purchase of sovereign debt on the secondary market is within its remit. What is less clear is whether the German government will allow such a thing to happen, and more importantly; whether it will actually work.

On this note, in a Bloc where balance sheet reform for all governments remains at the centre of every political and policy discussion; there is an increasingly impotent argument in favour of what lower borrowing costs and additional liquidity can actually do to promote economic growth.

This dynamic increases the risk to the continent because if the market begins to view the ECB as powerless to avert disaster, then fears of another collapse or catastrophe could become a self-fulfilling prophecy.

It is for the above reasons that demand, or buy side stimulus is now occurring as a topic of conversation with increasing frequency.

Our view is that, in the absence of an effective asset purchase program, demand or buy side stimulus agendas will be key for the longer term continental recovery, most notably because of disparities in the bloc’s economic makeup, and the knock on impact of this upon the dispersion of the benefits that arise from recoveries elsewhere in the world.

With external trade for peripheral economies mostly dependent upon fruit, vegetables and other low value & low tech exports; there is little evidence that any subsequent improvement in economic prospects for the likes of China and the US will actually benefit these economies.

Thus, the backdrop of improving growth elsewhere will have little relevance to some of the continent’s most indebted nations (i.e Greece, Portugal).

In addition to this, and looking at the core of the continent; exports from France make up a relatively small portion of annual output for the nation. For this reason, a stronger recovery in the US and a slower slowdown in China will be of little comfort to French economy ministers.

With little room for expansion of government or household balance sheets, and low or negative interest rates having had little impact upon domestic credit demand; the suitability of a US style asset purchase program is rightly called into question. As a result, the importance of an alternative to monetary stimulus on the continent is now underscored.

While the question remains open as to whether or not stimulus measures that require greater fiscal expenditure will actually pass the budget masters in Brussels and Frankfurt; the important point to take from this is that officials in various segments of the union are now actively looking for alternative means of stimulating demand and thus, growth.

This could be positive for the bloc over the medium to longer term, particularly in the event of an eventual asset purchase program proving ineffective.

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