The Eurozone economy isn’t holding up too well. Growth has stalled. A number of Eurozone countries are in recession, and the region as a whole is just above water.
Last month, Eurozone inflation slowed to a five year low of 0.3%, well and truly in the ‘danger zone’ — below the European Central Bank’s (ECB) 2% target.
Europeans have little hope that things will turn around — inflation expectations are also at record lows. While the region emerged from recession in the second quarter of 2013, the recovery has been weak and it’s close to sliding back there.
Most of the pain has been centred in the smaller economies — Greece and Spain, for example, which have seen extreme unemployment. Yet the region’s three largest economies — France, Germany and Italy — are increasingly weak too.
The Eurozone’s largest economy, Germany, is suffering as a result of weakening global demand. German industrial production fell in August to its lowest level since February 2009. This is a big problem since the Eurozone depends on the German economy to support growth.
Italy has been in a recession for two years. France’s economy has been stagnant for months. And now, the region is at real risk of deflation.
On the surface, deflation — or falling prices — might sound like good news. But deflation is a huge problem for struggling economies as it discourages spending. When consumers expect lower prices in the future, they delay purchases and spend less today.
Lower spending further depresses the economy, leading to spending cuts, which could push the economy back into recession. Additionally, wages and prices don’t adjust as quickly as needed to keep supply and demand balanced, leading to higher unemployment.
Deflation also raises debt burdens, which reduces spending power. Seven Eurozone countries are expected to have debt-to-GDP ratios of over 100% next year. The proportion of loans in default is rising in Portugal, Italy and Greece.
ECB President, Mario Draghi, says officials should stoke inflation ‘as fast as possible’. Printing money to buy bonds — known as quantitative easing, or QE — would in theory boost inflation and add to growth.
Still, there are doubts that QE would have much of an impact. Interest rates can’t get much lower. Getting the region’s economy back on track relies heavily on individual countries taking action by making unpopular spending cuts. Actions like raising the pension age and cutting unemployment benefits.
The ECB holds its policy meeting tonight. Few expect them to announce a new round of QE.
Draghi’s deputy, Vitor Constancio, said tonight’s meeting is too soon to assess whether the bank should buy bonds. He expects a decision in early 2015, after they’ve had a chance to judge the effects of the existing programs.
Economists expect that the ECB to hold back on any further stimulus until its March meeting. But as the economy continues to decline, the heat is on.
The euro will fall lower still
For the Eurozone to get back on track, it is crucial that the euro is low. The currency is currently trading at US$1.23, down from close to US$1.40 in May this year.
Analysts say it needs to fall further. A return back to US$1.40 would make a recovery impossible.
The ECB are intent on keeping the currency weak. Draghi intended to push the currency lower when he said the central bank wouldn’t hold back on taking steps to stimulate the economy. That speculation itself — without any actual action — was enough to drag the euro down against the US dollar.
There’s good chance the euro could drop to US$1.15 next year — and then to US$1.10 by the end of 2016. As long as there is a risk of additional stimulus from the ECB, the euro will remain under pressure.
Opportunity for investors
On the bright side, European stock markets have been outstanding in recent months.
The benchmark German Stock Index, the DAX, has been especially strong. The index tracks the performance of 30 German blue chip stocks traded on the Frankfurt Stock Exchange, which represent around 80% of the market capitalisation.
The combination of the weaker euro attracting foreign investments, plus the weak economic data, has sent Germany’s market to record highs.
Yes, I said weak economic data. The worse the economic news, the more hope there is for quantitative easing and other stimulus measures.
An example of this came on Friday when investors pushed markets higher on the back of news that inflation had fallen to a five year low. The inflation data adds pressure on the ECB to take measures to spur growth and stave off the threat of deflation.
European stocks were up again last night ahead of tonight’s ECB policy meeting. This rally took the benchmark DAX Index to its July record last night.
However, some say the rise suggests the market is too optimistic. The DAX’s relative strength index shows that the index has been ‘overbought’ for more than a week. It hasn’t remained so high for so long in more than a year.
The index has jumped 16% from its October low to its now overbought level. If the ECB decide not to take any action tonight, it will leave the index looking pricey.
However, if the ECB do decide to introduce new stimulus, the index could certainly run much higher still.
There’s no doubt that economic fundamentals don’t look good in the Eurozone. As bad as things are in Europe there are certainly opportunities on offer.
Yet, the weaker euro plus any new stimulus — whether introduced now or early next year — will carry through to see the DAX jump to new highs. There are certainly opportunities for investors — despite the dire outlook for the area’s economy and how the whole mess will be resolved.
Guild members will be familiar with the DAX’s performance. Our DAX-listed multinational has returned 24% in just over four months. If you are interested in investing in the German market, you can easily do so with an international trading account. One of the Guild’s special reports, The Simple Way to Invest and Profit with International Stock, takes you through the process step by step. To learn more, click here.
And keep an eye on the market — this won’t be a set and forget situation.
for The Daily Reckoning Australia