Tuesday, April 23, 2013

What is happening with Germany?

Long-time readers will know that I have held an upbeat view with respect to Germany for a long time due to a number of reasons. One of the reasons has been the easy monetary environment provided by record low real yields (ongoing) as well as by the weak exchange rate. More important for Germany than the level of the trade-weighted Euro is the level of the EURJPY cross rate even though Germany does not have strong direct trade relationships with Japan. However, Germany and Japan are key competitors in the global markets for items such as cars, machines or chemicals. The collapse of EURJPY since the outburst of the financial crisis in 2008 has helped German exporters gain market share, especially in Asian markets, at the expense of their Japanese counterparts. Following the radical easing in monetary policy by the BoJ, EURJPY has shot upwards by approx. 30% within a matter of a few months.
EURJPY and EUR trade-weighted index

Source: Bloomberg 

This has important implications, not only for the German economy but also for the Eurozone overall:
a) The sharp rise in EURJPY constitutes a net tightening the monetary environment for Germany. German exporters are likely to face a more challenging export environment, especially in Asian markets. This will render the current economic upswing softer than would be the case otherwise.
b) The sharp rise in EURJPY does not have significant tightening effects on the other Eurozone economies, most notably France and the periphery. These economies compete to a much lower extent with Japanese exporters in world markets and hence a higher EURJPY is no issue. Rather, the likely flow of capital out of Japan (as the BoJ reduces the amount of JGBs available for private investors and hence cash needs to be invested elsewhere, likely also in Eurozone bond markets) helps to depress the yields of semi-core and peripheral sovereign bonds. Hence, the monetary environment in the periphery/semi-core gets more accommodative.
c) A weaker-than-expected state of the German economy increases the chances of further easing steps by the ECB (repo rate cut, moving into the direction of forward guidance, unconventional steps to promote the flow of credit to SMEs), supporting growth in the periphery via lower yields and a lower Euro (on a trade-weighted basis).

Overall, the German economy should see a growth recovery but a slower one than would have been the case otherwise whereas the support provided by the monetary environment for the periphery has been increasing and will increase further. As a result, growth differences between various Eurozone countries should become less pronounced.

Tuesday, April 16, 2013

Rising deflation risks in the Eurozone

I argued in November (see: No inflation pressures in the Eurozone) that inflation fears for the Eurozone are unfounded and rather deflationary risks in the periphery are significant. In the meantime headline and core inflation rates have fallen below the 2% target level. However, inflation pressures have continued to ease and inflation rates should be expected to fall markedly further to below 1% during summer.

The chart below shows the development of various inflation measures for the Eurozone. Headline and core inflation are well known. However, I also calculated a core measure ex administered goods and services. The price changes for administered goods & services are to a large extent directed by the sovereigns and amid the massive fiscal tightening in a large number of countries there has been significant upward pressure on the administered goods prices. Furthermore, I try to deduct also the effects of changes of consumption taxes on prices (Eurostat publishes a constant tax rate HICP). The green line shows this adjusted core inflation measure (i.e. a measure of inflation stripped off the effects of energy&food prices as well as the direct impact of fiscal tightening). This inflation measure stood at 0.4% in January. At that time, core inflation was at 1.3%. Hence, two-thirds of core inflation stemmed from higher prices for administered goods & services as well as higher consumption taxes. On a country level Spain is in outright deflation and France is at 0% inflation according to this measure.

Inflation developments in the Eurozone 

Source: Eurostat, ResearchAhead

Looking ahead, price pressures should ease markedly further. First, as headline inflation has been running above the core measures, prices for food & energy continued to exert upward pressure on inflation. However, as the chart below shows, Brent crude oil in Euros has already dropped by approx. 15% since early February and from where they stood a year ago. This is the largest yoy drop in oil prices since 2009 (i.e. at the height of the global financial crisis). Following a spike of approx. 40% last summer, also food prices (measured by the S&P GSCI Agriculture Index in Euros) have now turned negative on a yoy basis. As a result, the inflationary impact of food&energy prices should wane over the next months and headline inflation should fall to (and might even undershoot) the core inflation rate.

Year-over-year %-change of Brent crude oil in Euros

Source: Bloomberg

However, besides easing headline pressures, also core inflation rates should continue to fall further. For one, unused capacity in the Eurozone is at extremely high levels. Moreover, monetary developments remain very weak and M3 grew by only 3.1% yoy in February with the 6m annualised increase only at 2.1%. Within M3, M1 continues to be the main driver for M3 growth, while the broader aggregates continue to shrink. The 6m annualised change in M3-M2 has collapsed to -20% in February! As the chart below shows, growth in M3-M2 is a good leading indicator for core inflation and suggests that inflation pressures have been easing further. On the other side, credit growth remains very weak also, falling by 1.2% yoy in February. In Spain, loans for corporates are collapsing by almost 20% yoy and to households by 5%. But also in Italy, loan growth is negative while in Germany it stands at only 0% for corporates and 1% for households.

Growth in M3-M2 suggests easing core inflation pressures

Source: Eurostat, ResearchAhead

As a result, the combination of weaker energy and food prices on a year-over-year basis as well as very high unused capacity and very weak money and loan growth all suggest that core and headline inflation rates should fall markedly over the next few months. Sub 1% inflation rates during summer are very likely and should raise deflation fears.