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Market View

Monetary policy will buy policymakers time while the eurozone struggles to enact reforms. 

 

In Brief

  • In January 2015, the European Central Bank (ECB) announced a €1.1 trillion ($1.3 trillion) quantitative easing (QE) program, following the path of the Bank of Japan, the U.S. Federal Reserve, and the Bank of England. But even ECB president Mario Draghi has noted that monetary policy alone cannot solve the eurozone’s economic problems.
  • The QE program is unlikely to lift the eurozone’s inflation rate, which is hovering well below 1% annually. But it has already caused the value of the euro to drop versus the U.S. dollar, which should help Europe’s exporters.
  • Unless the eurozone enacts badly needed structural economic reforms, it faces the danger of slipping into Japan-style deflation and stagnation.
  • The U.S. economy, in contrast, continues to be healthy, despite some consequences of a stronger dollar and despite the signals sent by a flattening of the Treasury yield curve.
  • With the election of the far left, anti-austerity Syriza Party, the Greek debt crisis has resurfaced. But Greece presents much less of a threat to Europe’s financial system than it did in 2010. Greek bonds are now owned mostly by the International Monetary Fund (IMF) and the ECB.
  • Oil prices are likely to stay low for a year or more, barring a flare-up in geopolitical risk.
  • With the depreciation of the euro, Japan will face greater competition for its exports. That, and less dependency on exports, means that domestic economic reforms are more necessary than ever.

 

With the recent election of the far-left Syriza Party, Greece and its future in the eurozone are back in the news. Unlike in 2010, however, a default presents much less of a problem for the global banking system. Even with the recent announcement of a quantitative easing program, Europe is not out of the woods, however. Economic growth there remains mediocre even by European standards and increasingly brings comparisons to Japan. Both economies are in dire need of structural reforms, and both continue to struggle to implement those. Addressing these and other developments in the global economy are Lord Abbett Partners Milton Ezrati, Senior Economist and Market Strategist; Zane Brown, Fixed Income StrategistHarold Sharon, Investment Strategist, International Equity; and David Linsen, Director of Research.

Q: The European Central Bank (ECB) has announced a €1.1 trillion ($1.3 trillion) quantitative easing [QE] program to be implemented through September 2016. What are the implications for the eurozone economy?

Zane Brown: QE is probably going to have a greater impact on the value of the euro than on inflation. In the United States, the Federal Reserve [Fed] has created an awful lot of dollars via QE, and on top of that, the federal government has spent a lot of stimulus money and the banks have expanded their lending. But even with all these measures, inflation is nowhere near the Fed’s target rate of 2%. So I’m not sure the ECB’s QE program will be enough to create inflation on its own.   

On the other hand, the QE program has already pushed the euro lower. It wasn’t long ago that the euro was at $1.36 [as of July 6, 2014], and now it’s down to $1.15 [as of February 3, 2015, according to Bloomberg]. That drop gives European companies a huge advantage when they compete against U.S. companies. So I think ECB president Mario Draghi has done more to promote growth than he has done to create inflation.

The weaker euro should benefit Germany tremendously because 45–50% of its economy consists of exports.1 But it seems likely that other eurozone countries will benefit less.

Harold Sharon: I think the ECB’s plan is incrementally positive. But rates are already low, and banks already have liquidity. So, will it ultimately have an effect? I think it will lower the value of the euro a little bit, and that can’t hurt. It will help the exporters, but some of these countries have low net exports as a percent of GDP [gross domestic product]. Draghi made a good point in his press conference. He put the ball back in the politicians’ court, saying that monetary policy is not the solution. Monetary policy can create the foundations for growth, but growth won’t happen without investment, investment won’t happen without investor confidence, and investor confidence won’t happen without structural reform in the stagnant countries. 

Q. According to GaveKal Economics, 11 of 15 eurozone countries recently recorded year-over year declines in their consumer price indexes. Given the economic and demographic similarities with Japan, is the eurozone headed toward the same fate—deflationary stagnation?

Brown: The need for structural reforms is the biggest commonality between Europe and Japan, Germany aside. Japan needs to streamline its distribution systems, for example, and reform the protections they provide to the agricultural sector, as well as other measures to make their economy more competitive globally. Europe needs reforms of its own, particularly in its labor regulations. As for demographics, Japan has a very old population, but in Europe, it varies somewhat by country. 

Milton Ezrati: Germany and Italy are similar to Japan, while France and the Britain have younger populations, and they also have larger immigrant populations.

Sharon: There are significant economic differences as well. Exports make up a much smaller portion of Japan’s gross domestic product than in the past. One reason for that is the Japanese have exited numerous sunset industries, such as chemicals, that they would export to developing Asia. They don’t feel the need to be self-sufficient in these industries as they did in the past, and exports are now only 15% of GDP.2

Consumption is 60% of GDP. When consumption is so much greater than exports, a weak currency doesn’t necessarily provide an economic boost. So economies such as Germany’s, which is more export-oriented, would benefit more from a depreciating currency than some of the weaker eurozone countries where consumption is a larger part of their economy than exports are.  

It’s hard to roll back the welfare state benefits in Europe—that’s another difference Europe has with Japan. Those social welfare policies have been engrained for generations, and so it’s unlikely that Europe will ever grow at the rate that is possible for the U.S. economy. Even before the crisis, European economies did not grow as rapidly as that of the United States. If they grew by 1.5% in a year, that was considered good.

Brown: The other big difference between Europe and Japan is the potential for political discord. This potential is much greater in Europe, and it could get ugly, but it could help bring about political change sooner.

Q: What’s the outlook for Greece, now that the far-left, anti-austerity Syriza Party has won the election?

Ezrati: [Newly elected president] Alexis Tsipras talked about rescheduling or repudiating Greece’s debt, but he also talked about not doing that. So the Greeks don’t know which person they’ve have elected.

But I think the rest of the eurozone will move heaven and earth to keep Greece in the monetary union because they don’t want to set a precedent. If Greece gets a deal that gives its economy some relief from the austerity program, then the Italians, the Spaniards, and the Portuguese will want the same relief.

Sharon: At some point when the politicians at the extreme ends of the political spectrum get into office, they become aware of the institutional constraints around them, and realize they can’t do everything they set out to do without potentially damaging institutional support and longer-term policy frameworks that are there to help them. But they also quickly find the soft points in those constraints that would allow for some trade-offs. Syriza has been pretty clear that they don’t believe the austerity programs have worked, so if they could prevent another round of tax increases and spending cuts, they might be satisfied with that. And they might not get the outright debt relief they want, but they might get extensions on the maturities of that debt, which could provide some breathing room.

Brown: Even if Greece winds up leaving the eurozone, it will not have the impact on investors that it would have had two years ago when that possibility was first raised. Back then, Greek debt was widely owned.

David Linsen: The fear two years ago was also about contagion and financial exposure. While those risks are not eliminated, they are mitigated today.   

Ezrati: Today, Greek debt makes up only about 1% of European banks.3 So, the financial markets would not crash over that.

Sharon: Greek debt at this point is owned 70% by the IMF and the eurozone stability fund. The ECB owns a further 9%. There’s still around 12% owned by private investors, but I would assume they mostly entered in ex post facto.4

Q. Oil prices plummeted in 2014. How long will they stay low, and how much will that boost the eurozone’s economy? 

Linsen: Lower oil prices will be a benefit to the eurozone, but because of higher taxes there will not be as much of a benefit as there will be to the U.S. economy. In the eurozone, taxes amount to around 60–70% of the cost of fuel to consumers,5 so there will be only a marginal benefit. Lower oil prices will also help make some industries more competitive.

Brown: Oil is unlikely to revert to the mean, which is about $96 a barrel over the past five years,6 in the next 12 months. The drop in prices has been driven by oversupply, some of which is due to increased U.S. production as a result of “fracking.” Saudi Arabia, which has always been the swing factor in oil prices, has continued to pump, even though supply is plentiful. The Saudis realize that the marginal cost of these “fracked” wells is relatively high, so low prices would reduce competition from these U.S. producers.

Many wells that would have been drilled in the United States when oil prices were higher have now been halted. So, 12–18 months from now supplies could decline and prices could rise. But until then U.S. production is likely to rise because producers want to cover the costs they’ve already incurred in drilling the latest round of wells. I would think that 12–18 months from now we might see $60 a barrel.

Linsen: The U.S. oil rig count is down 28% from its peak, and expectations are that the count will drop by 40–60%. It takes a long time for this inventory of wells that have already been drilled and are in the process of being completed to have an impact on supply. But the leading indicators show that supply is likely to be reduced by 2016.

Ezrati: This oversupply situation was evident last spring, when oil prices were above $100 a barrel. But that price also reflected the geopolitical uncertainty at the time. Now that prices have fallen, that risk premium has been reduced. ISIS [Islamic State of Iraq and Syria], which was expanding last spring, seems to have stalled, and we’re in negotiations with the Iranians on nuclear development. So, this new price level reflects the supply-demand situation and a lower level of geopolitical risk. But if trouble develops in the Middle East, oil prices could go to $100 a barrel overnight.

Brown: It’s also in the Saudis’ interest for the price to be higher. The Saudi government must cover huge costs, including domestic social programs, and that means that they need the price to be around $92 a barrel [according to a Reuters survey of banks, consultants, and independent analysts].7 But the Saudis have a lot of financial resources, so they can probably go a year with prices at relatively low levels. So, absent a crisis in the Middle East, we probably won’t see $100 a barrel anytime soon.

Linsen: But the long view has been that if the United States continues to add a million barrels a year to production for the next several years, then the price will never get to $92 a barrel. So, by taking a lot of pain in the short term to realign the market, the Saudis may be hoping that over the long term the price will average out at a level that will enable them to cover those costs.  

Q: In the United States, some observers have pointed out that the Treasury yield curve is close to inverting, and that if it does invert, this would signal that a recession is likely soon. Is the U.S. economy in danger of recession?

Brown: The yield curve has flattened, but for completely different reasons than in the past. Typically, the yield curve inverts after a period of strong growth, which results in rising inflation. Then, the Federal Open Market Committee [FOMC] at the Fed responds by aggressively raising short-term rates in order to slow the economy and reduce inflation.

Today, the committee’s intent is much different. Instead of raising rates aggressively, they’re being cautious. All they’re trying to do is bring interest rates back up to normal levels. And they’re not trying to slow growth; they’re trying to boost it. They’re not trying to reduce inflation; they’re trying to create it. So, we really don’t have the preconditions that are necessary for a recession.

Ezrati: Treasury yields are low, but that’s because a lot of money is coming in from overseas. If you look at how the yield curve has changed, the long end of the curve has flattened, but the middle of the curve has risen, which means that investors are anticipating the Fed’s rate increases at least somewhat.

Brown: With the yield on Japan’s 10-year bond at 0.2% and the yield on Germany’s 10-year bond at 0.4%, the yield on the 10-year Treasury looks pretty attractive at 1.76% [data as of February 3, 2015]. And that is likely to continue, because overseas investors who invest here are likely to get a currency kicker. That’s because Japan seems likely to weaken the yen further and that the ECB’s QE could pressure the euro lower. And because China can’t afford to lose exports to either of those two countries, it could be forced to respond with a devaluation of its own.

So foreign investors who want some yield may be likely to invest in Treasuries, which could prevent the yield on the 10-year Treasury from rising much.

Ezrati: Just to add to what Zane said, there is nothing that is pre-recessionary about the U.S. economy. There are no excesses in the economy as would normally be the case prior to a recession, except for debt levels. But most of that is government debt.

Commodity prices are falling, which is consistent with a recession, but that reflects the slowdown in the global economy. And since commodities are priced in dollars, the lower prices are also a reflection of the strengthening dollar.

Q. What’s the outlook for Japan? Will “Abenomics” finally succeed in 2015?

Ezrati: Of the three “arrows” of Prime Minister Shinzo Abe’s economic policy, known as Abenomics—monetary stimulus, fiscal stimulus, and structural reforms—the first two are not new. They’re standard Japanese policy. Abe’s infrastructure spending program is typical of Japan’s Liberal Democratic Party: collect taxes and distribute it to your donors via infrastructure contracts.

The third arrow, which helps to address the demographic problem we’ve touched on, hasn’t been fired. The structural reforms that Japan needs have been known for years, but for political reasons it has been unable to implement them, and those haven’t gone away. So nothing has really changed in Japan.

And Japan can’t solve its demographic problem through immigration because it’s not going to allow a large enough number of immigrants in [to make a difference].

Brown: The hope was that Japan could boost its economy by devaluing the currency, but as Harold has pointed out, Japan has become less and less oriented around exporting. So there is less benefit to be gained from that.

And besides, Europe has now beaten Japan at its own game. The yen has fallen as a result of Abenomics, but the euro has now fallen more than the yen because of the ECB’s QE program. So now when Japanese machinery manufacturers, for example, are competing against machinery makers in Germany, Germany has an advantage.

Sharon: The Bank of Japan just came out with a report card on its inflation-targeting performance, which showed that although inflation had been rising, it has now fallen again. So the bank said it was committing itself to more QE.

Japan also is taking small steps to encourage firms to spend some of their cash on buybacks and dividends. Historically, Japanese firms have been loaded to the gills with cash because the banking system hasn’t functioned well since the early 1990s. So one of the other reforms Abe wants to implement are changes that would encourage firms to do more buybacks and dividends in order to get more of that cash into the economy. That would be an incrementally positive benefit to the equity market, and thus for household wealth and consumer sentiment.   

Ezrati: As Harold mentioned, Japan has withdrawn from some industries because it doesn’t feel as much of a need to be self-sufficient. Many of these industries are those that produce low-value products. So what Japan is now left with is high-value-added industries such as robotics. The problem is that devaluing a currency doesn’t help as much with these industries because higher-value products are less commodity-like, so price matters less.

Q. What else should investors keep an eye on in 2015? 

Brown: China has been trying to make home ownership available to more people, and demand for housing was strong as long as people continued to migrate to major metropolitan centers for work. But with global growth slowing, the country’s export sector is slowing as well, so there will less need for those workers and less demand for residential real estate. So, China’s property market is probably overbuilt.

That could have a significant effect on the domestic portion of the economy. Wealthy people in China have invested heavily in the real estate market, and unlike in the U.S. market where homebuyers are allowed to put down just a small amount, first-time buyers in China must put down at least 30% of the home’s value.8 So, if those investors now lose a significant portion of that equity, they will feel the need to save more in the future, which will hurt domestic demand.

This could only add to the pressure that China may feel to devalue its currency. China exports to Asia and to Europe, and in Europe, Chinese companies are competing with a substantially lower euro, and in Asia, they’re competing against a much lower yen. So if they don’t devalue, they would be at a disadvantage of probably 10–15% versus the yen and the euro.

Sharon: What a country does when it devalues its currency is essentially export deflation. Devaluation makes its products cheaper in other currencies and lowers its wage costs relative to the world. Thus competing companies face pressure to lower their prices and wages as well. Right now, the world doesn’t need any more deflation.

China’s devaluation in the 1990s had a significant impact on the rest of Asia. The devaluation stole the growth of the other export-oriented economies in the region and ultimately precipitated the Asian financial crisis in 1997–98.

Q. Thank you, gentlemen.

 

1 The World Bank, http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS, accessed February 4, 2015.
2 Ibid.
3 Bank for International Settlements.
4 Citi Research, December 2014, via www.zerohedge.com.
5 Europe’s Energy Portal, www.energy.eu/fuelprices, accessed February 4, 2015.
6 Brent crude prices from Bloomberg.
7 Rowena Caine, “Factbox—Oil Prices below Most OPEC Producers’ Budget Needs,” uk.reuters.com, August 15, 2014.
8 “China Home Buyers Rushing Online to Finance Downpayments,” www.bloomberg.com, November 5, 2014.

 

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