Just as the USA central bank, the Federal Reserve, has completed its Quantitative Easing or QE (money printing) programme; it seems increasingly likely that the European Central Bank will announce a European version of QE in coming months.
In simple terms, QE is a policy in which central banks buy government bonds to reduce interest rates. This is intended to lead to increased bank lending, confidence, spending and improved economic growth.
There is an increased sense of urgency at the European Central Bank as inflation has fallen to dangerously low levels. The recently released European December headline inflation rate fell to -0.2%, the first negative reading since October 2009. Lower oil prices were the major contributor.
This raises concerns that the European economy is falling into a deflationary (defined as a general decline in prices) spiral similar to what Japan experienced in the 2000’s.
What is the impact of deflation?
Deflation or falling prices arises because of a very weak economy, and more specifically a lack of demand for products and services. In this situation companies are continually forced to cut prices in order to generate sales.
You may ask why falling prices or deflation is not a positive development as prices for goods and services are getting cheaper? We are all more than happy to buy our new Samsung TV or Toyota car at a lower price!
So what is the problem with deflation? A major negative consequence of deflation is that falling prices for goods or services would likely lead to a fall in wages. A company that is receiving less for their products has various options to try maintain profitability. The company could lower wages to cut costs or in the worst case scenario could lay off workers leading to rising unemployment.
Another consequence of deflation for companies is that investment plans are likely to be cut given the returns a company can generate on this investment are likely to be lower.
Furthermore, indebted companies won’t survive as the fall in profitability will make it increasingly difficult to meet interest payments and this will obviously have a knock on effect to banks and overall economic activity.
In effect a deflationary backdrop leads to less job security, corporate profitability takes a hit and economic growth will slow.
Deflation also impacts Governments because incomes are likely to fall, which means less tax collection for governments, making servicing government debt more difficult. This is particularly important in Europe as Government debt levels remain alarmingly high.
You can see from the chart below that Eurozone government debt to GDP (Gross Domestic Product, a measure of the size of an economy) is rising. Greece, Portugal, Ireland and Italy have Debt to GDP ratios over 110% – compare that with New Zealand which has government debt at less than 40% of GDP.
Government debt to Gdp in Europe
Source: Deutsche Bank Research
In summary, Governments and Central Banks are desperate to avoid deflation as once an economy suffers from deflation it is very hard to get out of. We only have to look at Japan as an example of the destructive forces of deflation. Long running deflation in Japan has been associated with a stagnating economy, rising unemployment, corporate bankruptcies and high non-performing bank loans.
Risks of deflation are certainly rising in Europe and we are of the view that the European Central Bank Governor Mario Draghi will unveil QE in the coming months, potentially at the meeting on the 22nd January.
However, question marks remain about whether QE or buying of government bonds will work in Europe given bond yields are already at record lows in a number of European countries. For example, 10 year government bonds in Germany yield less than 0.5% and in France 10 year government bonds yield less than 0.8%.
Looking elsewhere, QE in the US and the UK certainly helped their economic recovery but the effectiveness in Japan is less clear. Economists in favour of QE in Europe argue that boosting asset prices (bonds and equities) will lead to a wealth effect in that consumers will feel better off and buy more goods and services, stimulating economic growth.
Time will tell if that is the case. A clear positive for Europe is the weakening we have seen in the Euro in anticipation of QE. This will give a much needed boost to the export sector in Europe.
In conclusion, there is still a lot of uncertainty in Europe and the range of economic outcomes is very wide. However, it is important to keep an “open mind” as an investor and there is still a chance of recovery in Europe. A combination of aggressive policy action, a weak euro, low oil prices and support from a strong US economy could surprise the many pessimists. Whether QE happens or not in Europe our focus at Milford is on finding world class European companies at inexpensive valuations that will benefit from the weaker euro.