Download Is Europe heading for Japanese-style deflation?

Is Europe heading for Japanese-style deflation?
The differences, parallels and implications for markets
by Martin Harvey, Fund Manager, Threadneedle International Limited
In this white paper, Martin Harvey contends that the parallels between the current
situation in Europe and Japan’s experience of deflation (a period involving a
sustained and general fall in prices) are sufficient for policymakers and investors to
be concerned. Martin believes that although there are many differences that should
ensure that the eurozone does not follow Japan’s fate, policymakers will need to act
forcefully if the risk of deflation intensifies.
Highlights
> There are many parallels
between the euro area today
and Japan in the 1990s
The recent decline of headline and core (a measure that excludes price changes
in more volatile components of an index) inflation measures across the eurozone
has heightened fears of a spiral into deflation akin to that which has blighted the
Japanese economy for the past 20 years. Indeed, the “Japanification” question is
now a regular fixture at the monthly ECB press conference, leading ECB President
Mario Draghi to point out the various differences between the two situations. In this
note, we will assess these differences as well as the parallels in order to gauge the
extent of the risk and potential implications for markets.
> The euro area appears to be
on track to avert deflation in
the short term
> However, many euro
countries are “one crisis
away from deflation”
The Japanese experience
> The European Central Bank
(ECB) claims to be ahead of
the game, but policy needs
to be more proactive
In order to find the ultimate source of the Japanese deflation spiral, one must go
back to the asset bubble of the 1980s, which peaked at the end of 1989. Following
a fall of more than 50% in the stock market over the next two years, stock prices
remained subdued for the remainder of the decade. Land prices (Exhibit 1) fell in
value from 1992 onward and have been in the doldrums ever since.
> Longer term, demographic
considerations and high debt
levels will pose problems
both in the euro area and
elsewhere
The real economy did not feel the most severe effects of the burst of the asset
bubble immediately, despite a swift collapse in money supply growth. Indeed,
nominal gross domestic product (GDP) continued to grow until 1997, unemployment
did not exceed 3% until 1995 and Consumer Price Inflation (CPI) — one measure of
the rate of change in prices based on a basket of goods purchased by consumers
— excluding-food and energy remained above zero until September 1998 (Exhibit
2) before remaining below or close to zero until 2013 when the Bank of Japan (BoJ)
began aggressive quantitative easing (QE).*
Exhibit 1: Japanese land prices have not recovered from the collapse
20
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
-10
1983
0
1980
%
10
Japan land price
Source: Reuters EcoWin, December 2013
*
Central banks normally try to boost economic activity by cutting interest rates in the belief that this will
encourage people to spend rather than save. But when interest rates are already very low, another option
is to pump money into the economy directly, and this action is known as quantitative easing.
IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Exhibit 2: Inflation in Japan remained negative from 1998 to 2013
6
4
CPI (%)
2
0
-2
Japan CPI % year over year
2014
2011
2008
2005
2002
1999
1996
1993
1990
-4
Japan CPI ex-food and energy % year over year
Source: Bloomberg, February 2014
There are a number of reasons why this process was something of a slow death
for the Japanese economy, and many of these reasons have been highlighted as
differences with the current situation in the eurozone. The key question for the ECB
to answer is whether the differences are sufficient to dismiss the possibility of
deflation, as the Japanese experience proves that once the process is underway,
it is difficult to reverse.
Progress report for Europe
In contrast to Japan, Europe’s asset price crash was part of an international
phenomenon. Although there were property bubbles in some euro area countries,
such as Spain and Ireland, this was generally not a concern. Initially, it was
Europe’s exposure to global trade that caused a steep drop in economic activity
in the wake of the Lehman collapse, while the onset of the sovereign debt (debt
issued by governments) crisis later played a part.
The scale of the initial drop in the EURO STOXX 50 Index (a stock index covering
50 stocks from 12 eurozone countries) was similar to that seen in Japan in the
early 1990s (Exhibit 3). Even with the recent rebound, stock prices are currently
around 30% below the peak of 2007. It is fair to use December 2007 as the
starting point for the comparison, as this marks the moment when spare capacity
began to build in the euro area economy.
On the surface, it appears that the Europeans are adopting correct policies as
the EURO STOXX 50 Index has surged over the past year and broken above the
levels reached prior to the debt crisis. Some regional indices, such as the German
DAX, have made new highs since 2008. This mirrors the divergence in economic
fortunes across the eurozone, where so-called peripheral countries (this refers to
countries on the geographic periphery of the eurozone) such as Greece remain in
significant economic difficulty while Germany is in good shape. Of course, certain
countries will have a higher deflation risk than others, adding another layer of
complexity to the situation. The ECB will be primarily concerned with the average
situation across the euro area.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Exhibit 3: Relative experience of equity prices from the peak of the bubble
Price
120
70
20
t-50
t-25
t
t+23
t+48
EURO STOXX 50, 2002–present (Dec 07=100)
t+73
t+98
Nikkei 225, 1985–2000 (Dec 1989=100)
Source: Bloomberg, March 2014. Note: t represents months before and after peak.
Exhibit 4: Relative experience of nominal GDP from the peak of the cycle
Nominal GDP
160
110
60
t-10
t-8
t-6
t-4
t-2
t
Eurozone annual nominal GDP (2007=100)
t+2
t+4
t+6
t+8
t+10 t+12 t+14
Japan annual nominal GDP (1989=100)
Source: Bloomberg, December 2013. Note: t represents years before and after peak.
Comparing the macroeconomic experience, Europe’s economic correction was more
abrupt than Japan’s. The level of nominal GDP has moved slowly higher since 2009
(see Exhibit 4), while the Japanese economy continued to expand at the beginning
of the 1990s. Furthermore, unemployment increased much more quickly in the euro
area than in Japan (Exhibit 5).
Exhibit 5: Relative experience of unemployment from the peak of the cycle
6
14
12
4
10
2
8
0
t-60
t-40
t
t-20
t+20
Japan unemployment rate, LHS (Dec 1989=t)
t+40
t+60
t+80
t+100
t+120
6
Eurozone unemployment rate, RHS (Dec 2007=t)
Source: Bloomberg, February 2014. Note: t represents months before and after peak.
3
IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Exhibit 6: Relative experience of core inflation from the peak of the cycle
4
CPI (%)
3
2
1
Eurozone core CPI (t=Dec 2007)
t+120
t+108
t+96
t+84
t+72
t+60
t+48
t+36
t+24
t+12
t
t-24
-1
t-12
0
Japan core CPI (t=Dec 1989)
Source: Bloomberg, March 2014. Note: t represents months before and after peak.
The international nature of the 2008 crisis and subsequent slow global recovery
goes some way to explaining the abruptness of Europe’s decline. Cultural factors
also contributed to the gradual pace of Japan’s economic demise. Specifically,
within the banking system, bad loans (loans that the borrower is unable to repay)
were not realized in a timely fashion in Japan and were simply rolled over, leading
to the build-up of so-called “zombie companies,” or firms commonly defined as
loss-makers, which helped by low borrowing costs, can only service their debts,
which continued to operate unprofitably. Consequently, as banks were not realizing
losses in a timely fashion, the subsequent recapitalization, or refinancing of banks,
that should have occurred was absent. Although this meant that unemployment did
not rise as quickly as it might have if more companies were allowed to fail, it also
reduced the probability of new companies being set up, new loans being granted
and new jobs being created.
In Europe, there have been repeated attempts to avoid the same situation, via
stress tests (analysis designed to determine whether a bank has enough capital
to withstand the affect of adverse developments) and forced recapitalizations,
although the efficacy of such programs has sometimes been questionable. In
the crisis countries, “bad banks” have been created to remove bad loans from
bank balance sheets, and in the most part this has proved successful. Indeed,
the formulation of the banking union, and the subsequent asset quality review
(AQR), aim to solidify the situation further. Given that the European banking
sector remains large relative to the economy, there is probably more work to
do on this front.
It is possible that such actions have had a detrimental effect on lending growth,
as banks have been more concerned with getting their houses in order. Indeed,
the headline data show that private sector lending continues to contract across
the eurozone (Exhibit 7). A recovery in this metric will play a vital role in averting a
situation similar to that experienced in Japan, where credit growth was non-existent
or in contraction from 1995 to 2013 (Exhibit 8). This will be one of the key data
points on the ECB’s radar, indeed it may even become a policy target.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Exhibit 7: Euro area credit growth has been in contraction since 2012
15
% year over year
10
5
0
-5
05
06
07
08
09
10
11
12
13
14
Euro area lending to the private sector
Sources: ECB, Bloomberg, February 2014
20
15
10
5
0
2005
2003
2001
1999
1997
1995
1993
1991
1989
-10
1987
-5
1985
Annual percent change (year over year)
Exhibit 8: Japanese credit growth remained positive until the late 1990s
Japan credit to the private sector
Sources: ECB, BoJ, Japanese cabinet office to 2005.
The Asian crisis of the late 1990s increased the stress in the Japanese financial
system and led to corporate failures and a surge in unemployment from an already
vulnerable position. This, alongside the ill-fated increase in the consumption tax
rate, was the final straw that sparked the descent into 15 years of deflation.
Despite the current relative economic optimism in Europe, given the euro area’s
current weak position, an exogenous shock (a shock emanating from outside
an economy or economic area) could push the economy into a similar
deflationary abyss.
One could argue that the sovereign debt crisis has already provided that shock
and the recent trend in inflation would support this theory, particularly in stressed
countries such as Greece. The speed and durability of the nascent recovery
should help the situation in the near term, but any shocks to growth would be very
damaging, especially considering the additional debt burdened upon Europe since
the beginning of the crisis. The potential consequences of slowing growth in China
should also be considered, as this development has the potential to exert an
added disinflationary (a slowing in the rate of inflation) impulse.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Policy response
Monetary policy:1 (see page 8 for definition): When he is quizzed about the
similarities between the current eurozone situation and Japan’s lost decade, Mario
Draghi is quick to point out that the ECB reacted much more quickly than the BoJ in
the early 1990s. Given that inflation was running higher in Japan at that time, the
policy, or key interest rate, was not cut to below 1% until 1995 when headline CPI
was first flirting with zero.
As Exhibit 9 shows, the policy rate remained higher than CPI throughout the 1990s,
leaving real rates too high during the period. Conversely, on this measure at least,
real rates have remained negative in the euro area since 2009 (Exhibit 10). It is,
however, now getting too close for comfort, and the ECB will be keen to avoid a
situation where CPI is entrenched below the level of interest rates, the so-called
liquidity trap where policy is rendered impotent.
This analysis does not account for the transmission mechanism (the way in which
interest rate changes affect economic activity and inflation) to the real economy,
which is more challenging in Europe due to the lack of fiscal union. Undoubtedly,
real rates (interest rates taking account of inflation) in the periphery have remained
too high in recent years, although the ECB is hoping that the recent improvement
in financial markets and in economic sentiment should help to ease this situation.
Exhibit 9: Japanese interest rates remained above the inflation rate throughout
the 1990s
8
6
%
4
2
CPI
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
-2
1990
0
Policy rate
Source: Bloomberg, December 2003
Exhibit 10: Euro area interest rates have been below inflation until now
5
4
%
3
2
1
Headline CPI
2013
2012
2011
2010
2009
2008
-1
2007
0
Policy rate
Source: Bloomberg, March 2014
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
QE was eventually introduced in Japan in 2001 and was judged in hindsight as
half-hearted due to its limited impact. Given that deflation had been embedded in
the system for many years, it took an extremely aggressive QE policy from the BoJ
in 2013 to give the Japanese economy a chance of redemption. The ECB stands
ready to ramp up policy initiatives if inflation undershoots expectations from here,
and early reports suggest that it is prepared to be aggressive. However, the ECB
faces many institutional impediments that could hinder the process. It is likely that
any QE attempt will be aimed toward the aforementioned transmission mechanism,
in order to target policy in the places where it is most required. The preferred
option is private asset purchases, but the problems of “one-size-fits-all” monetary
policy will remain a challenge. Striking a balance where policy is accommodative
enough for the periphery and not too accommodative for Germany is a very tough
proposition. The ECB has some way to go if it plans to rival the aggressive policies
of other nations since 2008 (Exhibit 11). To rival the scope of the UK QE policy for
example, up to €1 trillion will be required.
Exhibit 11: Central banks’ balance sheets have been inflated by QE programs
(Jan 08 = 100)
550
Index level
450
350
250
2014
BoE
2013
Fed
2012
2011
ECB
2010
2009
50
2008
150
BoJ
SNB
Sources: Reuters EcoWin, Bloomberg, February 2014
Exhibit 12: Relative experience of fiscal balances from the peak of the cycle
5
% GDP
0
-5
-10
t-9
t-7
t-5
t-3
t-1
Japan govt balance
t+1
t+3
t+5
t+7
t+9
Euro area govt balance
t+11
t+13
Source: Bloomberg, IMF, December 2014. Note: t represents years before and after peak.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Comparing inflation rates to other developed markets
> Given the influence of global factors such as food and energy prices, inflation rates have been subsiding across the
major developed markets, including the U.S. and U.K., where economic recovery has been uninterrupted for some time.
> The ECB has highlighted these similarities to justify inaction.
> Core CPI in Europe has undershot the U.S. and U.K. in the past couple of years as growth has diverged.
> Curiously, the International Monetary Fund’s (IMF) estimate of the output gap (the difference between the actual output
of an economy and the output it could achieve when operating at full capacity.is currently larger in the U.S. than in the
eurozone, although price trends suggest otherwise.
> High unemployment makes deflation a more legitimate concern in the euro area.
Figure 1: Core CPI in the U.S., U.K. and eurozone
Figure 2: The output gap in the U.S., U.K and eurozone
6
4
4
3
2
0
%
%
2
-2
1
-4
0
-6
U.K.
Eurozone
2% target
Source: Bloomberg, February 2014
2013
2011
2009
2007
2005
2003
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
U.S.
2012
2013
2014
-8
-1
Eurozone output gap, % GDP
U.S. output gap, % GDP
U.K. output gap, % GDP
Sources: Bloomberg, IMF, December 2013
Fiscal policy:1 Although monetary policy was arguably too tight in Japan, fiscal
policy was being used to boost demand throughout the 1990s (Exhibit 12).
Over many years of nominal (without taking inflation into account) GDP stagnation,
this drove the government debt stock to unsustainable levels, and although some
commentators claim that this was a necessary policy, the full consequences
remain to be borne. This is a classic case of crowding out, whereby bank balance
sheets are devoted increasingly to government debt at the expense of the real
economy, and the additional government spending eventually becomes a negative
influence on growth.
In Europe, by contrast, a strong effort has been made to limit the build-up of
government debt following the early years of the crisis. However, this determination
has ebbed of late, and the sharp drop in economic activity caused by aggressive
fiscal consolidation has meant that debt ratios have risen sharply in some
countries. European policymakers should continue to prioritize fiscal consolidation
to avoid a situation where deficits are maintained but with no discernable positive
impact on the economy. Southern European banks have been investing heavily into
government debt in recent years (Exhibit 14), which is reminiscent of the Japanese
experience. As yields (the income from an investment) decline, the incentive for this
trade should be reduced, but this will continue to be a key trend to monitor.
1
Monetary policy is one of the ways, along with fiscal policy, in which a government attempts to control
an economy. It involves measures such as increasing or decreasing the level of interest rates, which
affects the cost of borrowing, or changing the amount of money banks need to keep in their vaults, which
influences their ability to lend. Fiscal policy, by contrast, refers to government spending and tax policies.
8
IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Eur (LHS)
2014
2013
2012
2011
2010
%
1.5
2009
10
2008
2.0
2007
15
2006
2.5
2005
20
2004
3.0
2003
25
2002
3.5
2001
30
2000
Eur trillion
Exhibit 13: Bank balance sheets are shrinking in Europe
% of nominal GDP (RHS)
Source: Reuters EcoWin, February 2014
Exhibit 14: Banks have increased holdings of government bonds
12
% of bank assets
10
8
6
4
Spain
2014
2012
2010
2008
2006
2004
2002
0
2000
2
Italy
Source: Reuters EcoWin, February 2014
Structural reform: European policymakers are right to emphasize supply-side
reforms as vital to improving the long-run growth potential of the economy. Indeed,
some of the disinflationary pressure already evident in countries such as Spain
is a direct result of these policies bringing down cost pressures in an attempt to
boost productivity (a measure of the efficiency of an economy). One must bear in
mind, however, that the growth benefits of such policies are only felt in the long
term and are in many cases relatively small. In an ideal world, inflation would pick
up in Germany, allowing Spain to continue to gain competitiveness without outright
deflation. This reiterates the challenge of a one-size-fits-all monetary policy. A key
component that will define the success of Japan’s new push to leave deflation is
structural reform, or those that improve the underlying performance of an economy,
the so-called third pillar of Abenomics (named after Japanese Prime Minister Shinzo
Abe). Although progress on this front is much slower than monetary expansion,
the determination is there to move forward. Euro area policymakers have been
emphasising the importance of supply-side policies (policies designed to make
markets and industries operate more efficiently and contribute to faster growth)
throughout the crisis and will continue to try to improve the overall growth potential
of the economy. Once the added benefit of monetary stimulus ceases, this is what
will matter.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Effect of low inflation on government debt
> Peripheral governments, particularly in Spain, are specifically targeting so-called “good deflation” to improve
competitiveness.
> How do you separate good deflation from bad?
> The scenarios below assume a swift move to fiscal surplus and solid GDP growth, alongside an average interest cost of 3%.
> The exhibits show how difficult it becomes to stabilize debt in a deflationary scenario.
> Against this backdrop in Japan, domestic banks loaded their balance sheets with government debt, a process that has
already begun in Spain and Italy.
Good scenario
Inflation = 0
Inflation = -2
Sources: Threadneedle, IMF, December 2013
Good scenario
Inflation = 0
2027
2025
2023
2021
2019
2017
2015
2027
40
2025
40
2023
90
2021
90
2019
140
2017
140
2015
190
2013
190
2013
> This “crowding out”2 added to the drain of funds from the private sector.
Figure 1: Italy government debt/GDP scenarios
Figure 2: Spain government debt/GDP scenarios
Inflation = -2
Sources: Threadneedle, IMF, December 2013
The demographic consideration: The lack of population growth contributed in no
small way to the demise of Japan’s growth potential and consequent stagnation.
Exhibit 15 shows a striking correlation between the growth in the labor force and
core CPI. Europe faces some of the same problems as Japan, in particular in
Germany where the working age population peaked in 1998. France shows up
favorably on this scale due to a high birth rate, but the rest of the euro area is more
in line with Germany (Exhibit 16). As populations subside, spare capacity naturally
rises as aggregate demand (the overall demand in an economy) is reduced, leaving
a heavy deflationary influence.
Projections for the growth of the labor force remain positive across the major
eurozone countries in the coming years, so this is not an obvious concern, but
should remain on the radar. Indeed, this is a concern for all developed nations over
the coming years, as an ever-smaller percentage of the population will be expected
to provide for the remainder.
The challenge for governments is enacting policies that encourage more of the
working age population to work, which is something that has been a struggle for
Japan and which Abenomics is attempting to address. Germany has been much
more successful in this area and the focus on structural reforms in the euro area
should be generally positive. However, the headwind that this trend produces in the
medium term should not be ignored.
2
Crowding out refers to the theory that high levels of public spending affect the ability of the private sector
to raise funds.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Exhibit 15: Japanese population decline contributed to deflation
7
CPI ex-food and energy, % yoy
2013
2009
2005
2001
1997
1993
1989
1985
4
3
2
1
0
-1
-2
-3
1981
%
6
5
Japan labor force, 8q/8q %
Sources: Bloomberg, OECD, December 2013
Exhibit 16: Japanese population declining much more quickly than in Europe
Index=100 at peak year
(next to country name)
Working age population (14-65)
102
Index level
98
94
90
86
82
-20
-16
France 2077
-12
UK 2071
-8
-4
0
4
Years from peak
EA ex-Germany and France 2011
8
12
Germany 1998
16
20
Japan 1995
Source: Barclays, UN, January 2014
What the market is saying
The recent surge in equity prices suggests that investors are confident that the
euro area economy, with a bit of help from the ECB, can avert deflation as the debt
crisis of 2011–2012 becomes a distant memory. However, with inflation at low
levels, equity investors will remain sensitive to any exogenous shocks that could
put further pressure on the outlook for inflation and growth.
German bond yields have remained low despite aggressive sell-offs in the other
major developed bond markets over the past year. Partly this is justified by the
divergence in policy stance, with the U.S. and U.K. moving toward rate hikes and
the ECB still threatening rate cuts. However, the extreme suppression of the
term premium (the amount by which the yield on a long-term bond exceeds that
of a bond that will mature in a shorter time) suggests that some expectation of
persistent low inflation is embedded, which again contrasts with the U.S. and U.K.
where recent low inflation data is brushed off.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
Compared with the experience in Japan (Exhibit 18), where yields did not fall below
2% until 1997, risk-free yields are very low in Europe, but this has been the case
for much of the last few years. If low inflation persists, it is still hard to argue that
bunds (bonds issued by the German government) offer much capital appreciation
potential, although they may be attractive on a relative basis versus other assets.
If the ECB can convince market participants that Europe is more like the U.S.
than Japan, then yields could rise significantly, but this seems a distant prospect
at present.
Exhibit 17: European equity markets, regional indices rebased to 2007
140
120
Index level
100
80
60
40
20
2003
2005
Dax
2007
2009
Cac
2011
IBEX
2013
FTSE MIB
Source: Bloomberg, March 2014
Exhibit 18: Relative experience of bond yields from the peak of the cycle
9
8
7
%
6
5
4
3
2
1
0
t-12
t
t+12
t+24
t+36
t+48
Germany 10-year yield
t+60
t+72
t+84
t+96
t+108 +120
Japan 10-year yield
Source: Bloomberg, March 2014. Note: t represents months before and after peak.
One curiosity that inspired the ECB to step up its rhetoric and mention the
possibility of QE is the strength of the euro. There are a number of reasons why
the euro has continued to strengthen in spite of the divergence in interest rates
mentioned above, most notably the return of investment capital and the continued
retrenchment of the European banking sector. There are some further parallels
here with Japan, where years of currency strength undermined attempts to break
away from deflation, even though exports were noticeably harmed.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
However, when putting the two situations in parallel, the euro’s move pales into
insignificance. Indeed, the appreciation over the past 12 months is in the region
of 5%, compared with 15%-20% gains in the yen in 1999 (Exhibit 19).
Exhibit 19: Relative experience of trade-weighted exchange rates from the peak
of the cycle
180
160
%
140
120
100
80
t-36
t-12
t+12
t+36
Trade-weighted euro, Dec 2007=100
t+60
t+84
t+108
Trade-weighted yen, Dec 1989=100
Source: Bloomberg, March 2014. Note: t represents months before and after peak.
Summary
There are enough parallels between the current situation in Europe and Japan’s
deflationary experience for policymakers and investors to be concerned. It seems,
however, that at this point, the euro area economy’s fate is in the hands of those
policymakers. Recent commentary suggests that the ECB, the only institution with
enough firepower to act aggressively, is wary of these risks and ready to react
to further downside as and when it emerges. Draghi has always been keen to
warn investors not to question the ECB’s firepower, and until now they have not.
If downside risks do emerge in the coming months and quarters, the fight against
deflation could prove to be his toughest test yet.
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IS EUROPE HEADING FOR JAPANESE-STYLE DEFLATION?
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managed by Columbia Management Investment Advisers, LLC.
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CM-TL/249290 A (07/14) 4801/967934