ACUZ - Lucian Cornescu

‘Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation,” wrote the US economist Irving Fisher in 1933

Secular stagnation?

First, a workable definition of secular stagnation is that negative real interest rates are needed to equate saving and investment with full employment. Second, the key worry is that secular stagnation makes it much harder to achieve full employment with low inflation and a zero lower bound on policy interest rates. Third, while it is too early to tell whether secular stagnation is going to materialise in the US and Europe, economists and policymakers should start thinking hard about what should be done if it does. Doing so is a no-regret option.

Germany’s economy stagnated in the second quarter of 2014; Italy and France shrank by 0.2%. And since 2012, inflation in the eurozone has been falling steadily, down to just 0.3% last month. In response, the boss of the European Central Bank, Mario Draghi, last week slashed interest rates to 0.05% – a Rizla paper above zero – and signalled that Europe will, like the US, Japan and the UK, print money.
From Francesco Filia, CEO and CIO of Fasanara Capital, excerpts from September 1 Investment Outlook letter

Deflation in Europe is Just Beginning

Differently than Russia/West crisis, the problem of deflation in Europe is far more structural of an issue, likely to hold the stage for the foreseeable future.
As often stated, we believe Europe looks like Japan in the early 90’s. Similarly to Japan, Europe has few unmistakable connotations at interplay:

High level of indebtedness, drawing resources away from productive investments into sterile debt service.
Overvalued currency, especially to peripheral European countries (30% overvalued against D-Mark, 40%+ overvalued against the rest of the world). Peripheral Europe is experiencing a currency crisis as if they borrowed in foreign hard currency.

Secular trend of falling working population mixed with falling productivity rates.
The data released in the past few weeks provided evidence of European growth having grounded to a halt for most countries, including Germany. Italy dipped in triple-dip technical recession, while France slowed down concerningly and even Germany contracted in Q2. All the while, inflation averaged 0.3% for the Euro Area as a whole, well below the ECB target and on a clear downtrend.
In Japan in the early 90’s, it took four years for disinflation to become deflation, under the push of a strong Yen and with the help of an inactive Central Bank dismissing such risk until late.

Likewise in Europe, the EUR is far too strong when measured against GDP growth prospects and productivity trends. A misleading current account surplus of 200bn only managed to make it stronger (overshadowing imbalances across countries in Europe), together with a shrinking balance sheet of the ECB for almost Eur 1 trn on deleverage flows and LTROs repayments.

In crafting crisis resolution management, European policymakers blamed the lack of reforms for the low levels of productivity, whereas Europe was suffering from a structural lack of demand. A much more dominant problem. Given that, the ECB balance sheet was allowed to shrink for almost two years now, the EUR was allowed to strengthen against most currencies around the world (which were actively engaging in the opposite effort, one of bold currency debasement, ranging from the US, to the UK, to Japan.. including even Switzerland and Norway), and austerity was imposed to shrink fiscal deficits. The candidly stated goal was to drive Internal Devaluation across peripheral European countries, so as to close the competitiveness gap to northern Europe: output contractions, wage declines, fall in prices. Almost the opposite of what should have happened if the problem was diagnosed as one of deficient demand. Tightening fiscal and monetary policies took place in Europe for two consecutive years, all the while as most other large economies were engaging in the polar opposite.

Nomen omen. Internal Devaluation in Southern Europe is itself an intentional form of deflation. It should have been confined there where it mattered to level off imbalances across nations in Europe. Instead, the laboratory experiment failed as it metastasized around.

Globally, other structural forces were inductive of deflation, from robotics and technological advances shedding jobs and depressing input prices (the Amazon effect), to low energy prices (on shale gas revolutionary discoveries and the end of the Commodity super-cycle), to weaker than potential growth, slack in the labor market, weaker dollar on ZIRP policies, Yen devaluation exporting deflation, China slowing down, etc.

The result is that Germany’s GDP itself is in tatters, even before considering the damage to be from trade wars with Russia. Deflation took hold and derailed the improvement in the soft data and surveys projected earlier on.

The problem with deflation is that minuscule levels of GDP growth are unable to drive unemployment lower and unable to prevent debt ratios from grinding higher and posing a larger threat down the line. Mathematically, as primary budget balances are lower than the difference between real GDP growth and real interest rates on public debt, the debt/GDP ratio is set to rise, from already alarming levels.
Italy, is the main vulnerability here, as a debt/GDP ratio might reach 140% by the end of this year, thanks to disinflation and GDP contraction, and despite austerity and a 2% primary surplus on GDP. By the same token, thanks to zero inflation rates, real rates are too high in Italy, standing at over 200bps above France and 250bps above Germany.

Zero inflation is like death penalty to debt-laden countries. It has been estimated that Italy would need a primary surplus of ~8% if it wanted to stabilize its debt/GDP at zero inflation, which means just stopping it from moving even higher. Spain would need a primary surplus of 2%+, instead of current negative 1.44%. Which means more austerity and more contractionary policies, to cause more internal devaluation than it is currently the case, more declines in unit labor costs, more salary cuts, more unemployment, less consumer spending, less corporate investments. In Italy, for example, average salary would have to be cut by an additional 30%/40% before closing the competitive gap to Germany. This does not account for the fact that inflation in Germany is itself on the verge of becoming negative, making the necessary adjustment even more painful than that.

The good side of the story is that we believe that the ECB and fiscal authority will be forced into further action from here, in an attempt to avoid a fully-fledged debt crisis and a long period of Japan-style depression.
Germany is the key determinant of European policymaking, all too obviously, and we believe they might be about to give in to request for expansionary policies, both fiscal and monetary.

Few reasons for it:
The German economy itself is contracting, hardly a satisfactory result after many years of implementation of their policy recipe.

German inflation itself is borderline negative. Europe-wide inflation expectations have dis-anchored from 2% desired line, falling off 20bps in August alone (both 10y and 5y5y forward inflation swap curve). Any concern about price stability and Weimar-style inflation risk should have been put to rest by now.

German concerns with moral hazard on the side of weaker European member states should have abated by now, as most political parties have embraced structural reforms as essential, and married their political agendas to it. Government in France, Greece and Spain have already spent their political capital embracing the German agenda, being now certain to lose in future elections, while the Italian government is close to do the same, having credibly committed itself to reforms. Germany faces the best mainstream political parties in Europe they can aspire to; any future coalition is most certain to be less receptive of German’s diktat than these ones. The calendar of national elections across Europe next year and beyond should serve as a countdown. Thus, we believe Germany should be prepared now for a relaxation of austerity policies and spreading the adjustment process of fiscal consolidation over a longer time horizon, while opening up to real monetary stimulus.

Confrontation with Russia, while it may ease over time, surely highlights the urgent need for a common defense policy / energy policy across Europe, helping the case for integration in Europe in the short-term, softening German resistance to more expansionary policies.
In summary, we believe the ECB will be allowed to engage in non-conventional monetary policies, their version of QE, pushing equity and bonds higher in Europe, compressing spreads and yields further, within the next 6/12 months.

Whether it is going to be enough to avert a currency/debt crisis in Europe in the long run is a different matter. We think that there is a genuine case to be made for seeing dissolution of the currency union down the line, in an attempt to save the European Union. Early days to visualize that, though. What matters to the financial markets is the next twelve months - the foreseeable future - and we believe the next twelve months to be highly supporting of financial assets in Europe, both bonds and equity.
Incidentally, we have for European assets and the ECB the same feeling we have for Japan and the BoJ. Abenomics has a high chance of failure, in the long term. Nevertheless, on the road to perdition, chances are that efforts will be stepped up and more bullets shot in an attempt to avert the end game. As stakes are raised, financial assets will be supported and melt-up in bubble territory, doing so at the expenses of a more turbulent end-game in the years ahead.

* * *

Implications of Deflation + ECB’s Activism: Yields & Spreads to Compress to Minuscule Levels, Equity Melt-Up First

As discussed in our previous Outlook, ECB policies and deflationary forces are two weapons firing in the same direction. From here, odds are high for European rates to move lower, credit spreads to narrow, risk premia to implode, interest rate curves to go flatter. That is financial repression at its best, with the added help of deflationary forces, putting any sort of risk premia and rate differentials under attack.

Without the ECB policy move, such process was less obvious. In the absence of an active ECB, such deflationary forces could have failed to drive rates lower and spreads narrower, as credit and risk spreads could have widened massively on fears of a replay of the sovereign and liquidity crisis of late-2011, mid 2012. Credit spreads could have widened out well in excess of base rates moving lower. An active ECB, moving decisively and unanimously (including Weidmann), helps generate the expectation of mutuality across Europe, rendering deflationary expectations even across European countries.

From our June Outlook: ‘’Pushing lower a 10year German bund yield of 1.35% might be difficult (although Japan shows the downside is still wide), but forcing lower a 2.75% yield on a BTP is easier, as it offers twice the yield of a Bund, for the same Central Bank. So it is easier to push down a 6% yield on a Greek govie (and its CDS at 450bps over), on the presumption of mutuality and ECB backstop. For the time being, until further notice’. Fixed income-wise, we expect yields to plummet, spreads to narrow further: Italian BTPs at 2%, and at 100bps spread over Bunds, 60bps over French OATs; 10year Greek yield at 5% and below, soon enough’’.

The impact on equity we expect is one of melt-up, at least in a first phase, pushing them into bubble levels, not supported by fundamentals but rather by the mix of lower yields, zero inflation rates, modest economic growth. Against this backdrop, we believe that the activism of the ECB can lead into 20%/30% upside for equities in Southern Europe, especially in the financial industry. Our favorite markets are Italy and Greece, which we think have the potential of being best performers in the next 12 months, although with heavy (realized) volatility along the way.

* * *
European Deflation Trades

Disinflation is just about to turn into outright Deflation in Europe. The ECB is active but most likely already late in the game, behind the curve, and unable to prevent deflation from kicking in. There are important consequences for rates and spreads in Europe, together with the level of the EUR itself:

Rates to reach new lows, especially in the far end of the interest rate curve, especially in Germany. Bunds 10yr yields moving flat to JGBs, Bunds’ 30yr yields below JGBs

Spreads to compress, both between peripheral debt and core European debt, and across the curve. Italian 10yr BTPs at 2% yield by year end, and at below 100bps spread over Bunds, below 60bps over French OATs; Greek 10yr GGBs at below 5%

Risk premia to implode, interest rate curves to flatten. Curve spreads to tighten, volatility spreads to compress, cross-spreads to narrow.

Concluding remarks

Secular stagnation proved illusory after the Great Depression. It may well prove to be so after the Great Recession – it is still too early to tell. Uncertainty, however, is no excuse for inactivity. Most actions are no-regret policies anyway.

“If the US experiences secular stagnation, the condition will be self-inflicted,” Eichengreen writes, making a point that applies equally to Europe. Secular stagnation would reflect a failure to address US infrastructure, education, and training needs. It would reflect a failure to repair the damage caused by the Great Recession in Europe’s financial sector. And above all, it would reflect a failure to support aggregate demand. “These are concrete policy problems with concrete policy solutions,” says Eichengreen, “It is important not to accept secular stagnation, but instead to take steps to avoid it.”

Koo is not very optimistic that the most troubled part of the world economy, Europe, will succeed in a policy change: “On the political front, the unfortunate fact is that democracies are ill-equipped to handle such recessions. For a democracy to function properly, people must act based on a strong sense of personal responsibility and self-reliance. But this principle runs counter to the use of fiscal stimulus, which involves depending on ‘big government’ and waiting for a recovery.” Whether one likes Koo’s argument or not, it helps to explain why Europe is having difficulty dropping policies that are widely disapproved among economists. However, the EU has shown a remarkable capacity to re-emerge from deep crises. Hence, we might follow the OECD and favour hope over experience.

ACUZ Conclusion:Policies that stimulate productivity growth and raise labour-force participation build in buffers against the zero lower bound by boosting persistent investment demand.