Eurozone to Continue to Stagnate

Terry Flanagan

David Zahn, head of European fixed Income and portfolio manager at Franklin Templeton, said secular stagnation in the eurozone is likely to last though 2015 regardless of whether quantitative easing is introduced.

Zahn said in a note that although third-quarter growth last year in the region was better than expected, the weakness of the German economy, which expanded by just 0.1% over this period, dented any optimism.

“On top of the existing internal problems of “lowflation,” shorthand for ultra-low inflation, weak demand and anemic credit growth, the deterioration in the external backdrop over much of 2014—rising geopolitical tensions with Russia, and the slowdown of the Chinese economy and many other emerging markets—has made a rapid return to meaningful growth across the eurozone unlikely, in our view, despite some positive signs, including the stabilization of many peripheral economies and the boost in competitiveness from the weaker euro,” added Zahn.

However Zahn said he also does not expect a full-blown recession for the eurozone this year, although growth may turn slightly negative at some point.

The market is expecting the European Central Bank to potentially introduce full quantitative easing at some point this year, despite opposition from Germany.

Franklin Templeton said this would mark a step change in the ECB’s role and could if the central bank purchases member states’ sovereign and corporate debt.

“We anticipate an announcement confirming QE’s introduction could see further compression of spreads between peripheral and core eurozone bonds, though as has been the case in other countries that have used it, the actual implementation of QE may trigger a modest selloff, in our view,” said Zahn.

Due to the eurozone’s weak fundamentals and the possibility of further monetary stimulus from the ECB, Zahn expects the euro to continue to fall this year.

He added that Mario Draghi, president of the ECB, will look for signs that the ECB’s existing measures are having some effect before making any decision, especially in the reinvigoration of lending to businesses.

Last month the ING Investment Management Risk Rotation Survey found that 64% of investors believe the European Central Bank will implement quantitative easing before the end of this year, with 27% expecting it to take place in the first quarter.

In the survey 60% of respondents cited a Eurozone crisis this year as a significant risk to their portfolios.

Valentijn van Nieuwenhuijzen, head of strategy multi-asset at ING Investment Management said in the report: “It is clear that there are very real concerns of a prolonged period of deflation which could – if investors are correct – twist Draghi’s arm when it comes to implementing a sovereign QE programme in early 2015. Whether this will be realised remains to be seen, but without a more US-like flexibility in thinking and commitment to doing ‘whatever it takes’ to reach the desired objectives, it will be a long time before Europe can be considered ‘healed’.”

In an opinion piece for Project Syndicate last week Draghi said that monetary union is not complete within the euro area.

Draghi said that to complete a monetary union, countries need to be better off inside the euro area than they would be if they were not members. However he does not expect to see permanent fiscal transfers between richer and poorer regions.

Instead countries need to be able to thrive independently be flexible enough to respond quickly to short-term shocks.

“This comes down to structural reforms that spur competition, reduce unnecessary red tape, and make labor markets more adaptable,” added Draghi. “If a lack of structural reforms leads to permanent divergence within the monetary union, this raises the specter of exit – from which all members ultimately suffer.”

Members also need to improve private risk-sharing by deepening financial integration and uniting capital markets.

“Indeed, the less public risk-sharing we want, the more private risk-sharing we need,” said Draghi. “A banking union for the euro area should be catalytic in encouraging deeper integration of the banking sector.”

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