Playing the Eurozone disinflationary trend

Posted on 03. Feb, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

The current emerging markets rout happens at the worst moment for Europe. As Eurozone countries have made the choice to export their way out of debt, they have made themselves increasingly vulnerable to the growth prospects in emerging economies.

The ongoing landing of the Chinese credit bubble and the sudden stop experienced by emerging countries running negative current accounts (Turkey, India, Brazil, South Africa…) will aggravate the Eurozone low inflation trap (figures 1a and 1b). As revealed by figure 1b, all sectors are currently experiencing a trend of disinflation, which points to a chronic lack of aggregate demand. The weak demand results in low inflation while an insufficient global inflation, by forcing uncompetitive peripheral economies into outright deflation, pushing up real interest rates and aggravating the debt burden, in turn weakens demand and growth/inflation prospects. While the European house is burning, the ECB remains stodgy, either waiting for the Karlsruhe court to rule on the constitutionality of the OMT, for the US dollar to appreciate on the back of the recovering US economy or maybe for inflation to get low enough to overcome the German resistance.

A subdued inflation environment commands a fall in interest rates, and particularly the ones of core nations, that serve as a reference for peripheral and corporate issuers. As illustrated in figure 2, the trends of the German Bund and French OAT bonds have recently turned positive, joining their peripheral counterparts. Core sovereign get back their role of havens as risk aversion makes its comeback into the markets (figure 3). Italian and Spanish long-term borrowing costs have lost their connection to risky assets in 2013 and have so far been spared by the recent surge in worldwide risk premiums. Therefore, their trend of convergence to core rates is so far left unchallenged.

In this context, we recommend playing the disinflationary theme through a mix of sovereign and corporate debts, while staying away from high yield debt, which is now in bubble territory according to the Radar.

Figure 1a: Euro Stat euro zone core inflation rate (Year on Year)


Figure 1b: Euro Stat euro zone core inflation rate (Year on Year)

Figure 2: Riskelia’s trend indicator on various euro zone debts (Germany, France, Italy, Spain, Investment Grade)

Figure 3: Correlation of euro zone debts with Euro Stoxx 50 (3 months rolling)

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