Is there room for any further disappointment?
Europe has suffered a stream of destabilising news this year. Firstly, there was January’s emerging markets crisis, which slowed the demand for European exports. Then there were EU parliamentary elections in May, which returned a large number of anti-establishment MEPs to Brussels and spurred David Cameron’s attempt to block the appointment of Jean-Claude Juncker as EU president.
In more recent months investors have also had to contend with fears of a Russian military intervention in Ukraine, tit-for-tat trade sanctions between the EU and Russia, and the bailout of Portugal’s second-largest listed bank, Banco Espírito Santo.
The possibility of deflation
Data that was recently released showed the eurozone’s economy slowing to a standstill in the second quarter of the year, raising more questions about the sustainability of Europe’s recovery and the possibility of deflation.
Now, as evidence of slowing growth in the second quarter of the year for a number of eurozone countries has also shown, questions about the sustainability of Europe’s economic recovery and the possibility of deflation intensify.
According to official preliminary data, Italy slipped back into recession in the second quarter of the year, with the economy shrinking by 0.2% after a 0.1% contraction the quarter before. Even Germany, the powerhouse of economic growth up until recently, seems to be suffering, with the economy undergoing a 0.2% contraction last quarter.
The danger is that the European Central Bank (ECB) may be missing the big lesson from 1990s Japan – that dallying over economic policy risks a deflationary spiral that’s hard to get out of.
Not that the ECB isn’t trying. In June, eurozone interest rates were cut to a record low, and banks began to be charged for holding cash reserves at the ECB. These extraordinary measures followed hard on the heels of a surprise fall in the annual rate of eurozone inflation to just 0.5% in May.
It’s just that the big gun of quantitative easing (QE) shows little sign of being fired yet.
The ECB’s reticence is understandable, even as the evidence of economic fragility piles up. For one thing, QE might be seen – in Germany at least – as providing indebted nations at the periphery with the breathing space necessary to ease up on their attempts to reduce their spending and budget deficits.
For another, the ECB found out two years ago that a pledge to ‘do whatever it takes’ on its own was enough to save the euro. It’s likely too that just the expectation that QE might be used has helped to support bond prices this year.
Something the ECB ought not to be concerned about is the notion that QE might unleash inflationary pressures and lead to a devalued currency. The US, Japan and the UK, which led the way on QE, have provided practical demonstrations that this need not happen.
If QE is, as some say, the tide that lifts all ships of the financial kind, then European stocks and bonds might benefit from a change of heart at the ECB. In the absence of QE, or presence of only a tiny bit of it, Europe may be set to remain a stock-picker’s zone.
What the ECB must be looking forward to and, perhaps, investors are being asked to also, is some sort of resolution to the crisis in Ukraine and Europe’s economic recovery gathering momentum during the second half of this year.
Certainly, there have been bright spots. Spain’s economy, for example, appears to have been on the mend. The economy there grew by 0.6% in the second quarter, reflecting perhaps a widening gap between countries that have embarked on convincing structural reform programmes and those that have not.
However, the International Monetary Fund forecasts economic growth across the region to be ‘a little over 1%’ this year. While that’s an improvement on last year’s contraction of 0.5%, it’s still only about one third of what is expected from the UK and about half the speed at which the US is forecast to grow.
To achieve even this, Europe’s economic slowdown last quarter leaves precious little room for further disappointment.
Eurostat, 14 August 2014
Istat, 6 August 2014
Destatis, Federal Statistical Office, 14 August 2014
Eurostat, Harmonised Index of Consumer Prices, 17 July 2014
Instituto Nacional de Estadística, 30 July 14
International Monetary Fund, July 2014