JULY 2013

ECONOMIC AND INVESTMENT COMMENTARY

Fundamentals:
Deflation Danger

The euro area is heading for a period of dangerously low inflation but the European Central Bank in unlikely to respond aggressively to counteract this.
In this edition of Fundamentals, LGIM economist Hetal Mehta examines the outlook for euro area inflation and the implications for economic policy. Any further negative shocks threaten to push the euro area into deflation, prompting fears of a Japanese-style lost decade, which could re-ignite the debate on debt sustainability for highly indebted countries.
heading for a fall? Euro area consumer price inflation has been on a downward trend since mid-2011. And aside from any near-term volatility, we believe that this trend is likely to continue well into 2014 before stabilising at a rate far below the ECBs target of close to but below 2%. Driving this disinflation are two broad categories: structural and short-term. The structural causes are concerned with underlying trends and fundamental economic issues facing the economy and are closely related to core inflation, while the short-term causes generally relate to movements in more volatile components such as energy and food prices which feed into headline inflation. STRUCTURAL DECLINE IN CORE INFLATION Although the ECB targets the headline rate of inflation, this is largely driven by movements in core inflation. So why is core inflation set to fall? Over the long term, core inflation moves in line with unit labour costs, i.e. wages per unit of output per worker (Figure 1), and in the euro area, these have broadly stabilised, so

INSIDE: Market overview: Taper tattle Snapshot: Abenomics Japans agenda for change UK forecast: Holiday season

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Figure 1. Core inflation moves with unit labour costs over time
10.0 8.0 6.0 4.0 2.0 0.0 -2.0 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Core CPI inflation, %Y/Y Unit labour costs, 3Y change, % %

Unit labour costs and core CPI inflation

Source: Reuters, EcoWin

no longer add upward pressure to core inflation. This has come about as a number of periphery countries embark on an internal devaluation - a downward adjustment of domestic production costs (Figure 2). This process is a key part of the post-crisis growth strategy, especially for periphery economies, to regain competitiveness, rebalance and gradually return to a model of sustainable growth. One element of this is the moderation in wage growth particularly in Spain, where wage indexation has largely been removed. In many countries public sector pay has been severely cut back, which has also had a knock-on impact on the private sector where wage growth is now more subdued. Also helping to reduce unit labour costs is the improvement in productivity, although so far this is largely due to the sharp falls in employment than rising GDP. But the labour market is a lagging indicator, so even as the economy stabilises, employment is likely to continue to fall, thus helping to increase productivity and lower unit labour costs (Figure 3).

Unemployment is also a related driver of core inflation. Europes sharp increase in unemployment from 7.3% at the start of 2008 to over 12% currently has reduced the amount of demand in the economy, meaning firms pricing power remains very constrained, which is putting downward pressure on prices. LGIM forecasts euro area unemployment to continue rising until it peaks at 13% in early 2014 (Figure 4), so we believe the negative impact of higher unemployment is set to continue. The ongoing structural reforms to liberalise product markets are also likely to generate greater price competitiveness and hence downward pressure on pricing.

The exchange rate is the final reason why we believe core inflation is set to continue on its downward trend. From the summer of 2011, when the euro crisis intensified, up until ECB President Mario Draghis whatever it takes speech and the announcement of the Outright Monetary Transactions policy in summer 2012, the euro was steadily depreciating, but since then the euro has appreciated by 8% on a trade weighted basis. This in turn has helped to reduce import prices, increasing the downward pressure on inflation. Bringing all these factors together (and assuming the exchange rate moves sideways) we forecast that core inflation in the euro area will average just 0.4% in 2014. HEADLINE INFLATION TO REMAIN WELL BELOW TARGET While the underlying trend in core inflation may be downwards, what about headline inflation which the ECB targets? This tends to track above core inflation as the price of volatile items such as energy and food generally increase at a faster pace than other prices.

Figure 2. Unit labour costs by country

Index, 2000Q1 = 100

140 130 120 110 100 90 2000 2002

Whole economy unit labour costs

Forecast

2004

2006 France

2008 Italy

2010 Spain

2012

2014 Euro area

Germany

Source: Reuters, EcoWin, LGIM estimates

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Figure 3. Contributions to euro area unit labour cost growth Contributions to y/y unit labour cost growth

8.0 6.0 4.0

%

Forecast

2.0 0.0 -2.0 -4.0 -6.0 2005 2006 Wages 2007 2008 2009 2010 Employment 2011 2012 GDP* 2013 2014 ULCs

*Positive GDP growth contributes negatively to unit labour costs

Source: Reuters, EcoWin, LGIM estimates

But even on this front, there are downward pressures. Back in April of this year, euro area headline inflation fell quite sharply, and largely unexpectedly, to 1.2% in year-on-year terms. While some of this surprise fall was due to temporary factors (and as anticipated there was a bounceback in May to 1.4% yoy), this downside surprise is likely to have played a part in the ECB cutting interest rates by 25bps to 0.50% in May. And lower oil prices, which are down over 10% in euro terms (Figure 5) since the start of this year, are only now starting to feed through into energy prices. Our projections of euro area energy price inflation of 3% factors in oil prices moving sideways until the end of 2013 before increasing $1 per quarter through 2014. Other short-term factors will also play a role in pushing down inflation. Both Spain and the Netherlands increased their VAT rates to 21% last year, representing increases of 3% and 2% respectively. These increases pushed up euro area headline inflation by around 0.2% at the end

of 2012, and so can be expected to shave off a broadly similar amount in the autumn when the increases fall out of the year-onyear calculations. But after these base effects wear off, we forecast that headline inflation will remain subdued and broadly steady, averaging just 1% in 2014, compared with the ECBs forecast of 1.3% (Figure 6). Despite all of the above reasons for expecting inflation to fall substantially below the ECBs target, we believe outright deflation in the euro as a whole is unlikely.

IMPLICATIONS OF LOW INFLATION Even if deflation was to materialise, short-term deflation is usually not particularly harmful as it boosts purchasing power. However, a period of sustained deflation, such as Japans experience, can become an entrenched vicious circle that may be hard to break. The negative impact of deflation, or even low inflation, will most acutely be felt by countries with high debt levels. Without the ability to inflate away the real value of debt, governments will come under pressure to proceed with both aggressive austerity plans to reduce the level of debt alongside further structural reforms to boost GDP, potentially leading to further economic weakness and a deflationary spiral, renewing market fears regarding debt sustainability. But even for periphery countries, higher inflation is no panacea. Being able to inflate away debt comes at the cost of losing competitiveness, particularly in a fixed exchange rate regime where a devaluation of the currency is not possible.

Figure 4. Euro area unemployment rate

34 30 26 % 22 18 14 10 6 2000 2002 2004 2006 2008 2010 2012 Italy 2014 Euro area Spain (LHS) Germany France

Unemployment rate

Forecast 14
12 10 8 6 4 2 %

Source: Reuters, EcoWin, LGIM estimates

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Figure 5. Oil price in dollars and euros

160 Price per barrel, $ and 140 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Dollars Euros

Brent crude oil

aggregate appears to be entering a prolonged deflationary period or if the growth outlook markedly deteriorates relative to the ECBs own fairly conservative forecasts. disinflation dilemma While it is true that many of the disinflationary pressures are coming from the delayed impact of the recent recession, these impacts can have very long lags, and are likely to exert downward inflationary pressure for many quarters ahead. In this environment, the ECB has a choice between preserving the purchasing power of savers in core euro area countries or keeping conditions for periphery sovereigns supportive; a most unenviable task.

Source: Reuters, EcoWin

DONT EXPECT MUCH FROM ECB Given this expected inflation undershoot, should we expect the ECB to react? And if so, what could it do? The ECB appears to have a very different reaction function to that of other major central banks such as the US Federal Reserve or Bank of England. If the US faced similar conditions, it is highly likely the Fed would attempt to combat a perceived deflation threat. Indeed, the Fed is still aggressively buying assets even though the US economy is growing faster, unemployment is lower and inflation rates are similar when compared with the euro area. Yet, the ECB is constrained by the often competing interests of the different member states. For example, Germany probably has a stronger preference for low inflation than Spain because the savings ratio is high, home ownership (and therefore mortgage indebtedness) is lower and renting is far more common. But this is not the first time the flaws of the one size fits all approach have been exposed. During the early years of the single currency, interest rates were arguably too low for many periphery countries in order to

keep conditions accommodative for Germany. The reverse may now be required. There are also concerns about the mandate of the ECB and whether radical policies such as quantitative easing (QE) would be compliant with the European treaty that set up the ECB. It is no secret that the Bundesbank is worried about both moral hazard and the overly loose monetary policy for Germany that the purchase of government bonds would involve. Overall, we think the monetary policy response will be limited. A further, small reduction in interest rates is possible, but there still seems to be much resistance to either negative interest rates or QE. We think the latter will only be deployed if either the euro area in
Figure 6. Inflation forecasts
4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 -1

CPI inflation

Forecast

%, y/y

1997 1998 2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015 Headline Core

Source: Reuters, EcoWin, LGIM estimates

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Market overview: Taper tattle

June brought further evidence of risk markets reliance on central bank stimulus. Federal Reserve chairman Bernanke confirmed that stronger economic data could result in the Federal Reserve scaling back its asset purchase programme. Although no specifics were given, this tapering news was enough to cause concern to investors and prompt volatility in equity and credit markets around the globe.
EQUITY OVERVIEW UK

Undulating equities
The gains made in UK equities in May were all given back in June as tapering and weaker Chinese growth fears weighed on sentiment. UK equities are currently at five-month lows. Its not all bad news though, within the housing market, prices have been firmer and there has been a marked increase in sales levels most likely the result of easier credit conditions. Carneys arrival at the Bank of England, and how he exerts his influence on policy going forward, will be closely monitored.
US

reversed all of this and last years gains and the S&P 500 was back below 1600. US investors were concerned about withdrawal of stimulus while US GDP remains low and debt remains high. It is worth noting that the Fed assured investors that tapering would only occur under the appropriate employment and growth conditions, but this reassurance has largely been ignored by investors.
EUROPE

Tepid growth
European stocks fell sharply on the prospect of a reduction in US monetary stimulus and Chinese growth concerns. MSCI lowered its rating on Greece to emerging from developed market status. However, encouraging European performance indicators have been released and inventories in the euro area are looking increasingly lean, which suggests that some boost to GDP from re-stocking is due. The euro zone announced another large trade surplus for April, up 14.9bn from 3.3bn at the same time in 2012, as imports remain weak.

As at 20 June 2013
Total return (denominated in ) Country 2013 year to date* (%) 2012 Calendar year (%)

Tapering fears
Last month, we said that only a hawkish statement from Bernanke himself on the scaling back of asset purchases would provide a reality check for investors. This month, he delivered this at the Federal Open Market Committee conference, and tapering talk dragged down risk markets across the globe. The US treasury 10-year yield, currently at 2.42%,

UK US Europe Japan Asia

7.5 16.7 9.5 18.9 -1.8

12.3 10.7 17.8 3.3 17.7

Source: Datastream, FTSEindices shown *as at 20/06/2013.

Figure 1. Major equity markets total returns (denominated in )

World equity markets, total returns 150 140 130 120 110 100 90 80 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov Dec 12 12 Jan 13 Feb Mar 13 13 Apr May Jun 13 13 13

FTSE All Share FTSE W Asia Pacific ex Japan FTSE W Japan

FTSE W North America FTSE W Europe ex UK

Source: Datastream, FTSEindices shown

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JAPAN

Figure 2. Major bond markets total returns (denominated in )

World bond markets, total returns 120 115 110 105 100 95 90 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov Dec 12 12 Jan 13 Feb Mar 13 13 Apr May 13 13 Jun 13

Abenomics loses its lustre

The tides changed in Japan, after the Bank of Japan failed to reassure markets that their stimulus efforts would work. There was a sell-off in the Japanese equity index, and bond yields on Japanese government bonds (JGBs) rose sharply. As the yen began to appreciate again against the dollar, hurting exporters, there were clear calls for better and more consistent communication from the BOJ officials. The success of the plan relies heavily on lifting sentiment and confidence, so the reaction in markets is important.

UK Benchmark 10yr Gilt German Benchmark 10yr Bund

US Benchmark 10yr Treasury Japan Benchmark 10yr JGB

Source: Datastream

ASIA PACIFIC/EMEA

FIXED INTEREST

Brazilian bother
Brazil produced disappointing growth numbers in the first quarter of the year. Although some of this may be temporary, a deteriorating job market is likely to weigh on consumer spending growth. Even with lower growth levels, the central bank has stepped up the pace of monetary tightening as inflation pressures have increased. Elsewhere, weaker Chinese data flow has continued with falling consumer demand and income growth: a likely knock-on effect from lower nominal GDP growth and the squeeze on corporate profits to wage growth. Scope for a new round of policy easing across emerging markets is limited but the recent commodity price decline has eased some of the inflationary pressure in this area.

Bernanke flips markets

Credit markets declined in line with other risk assets once Chairman Bernanke had made comments about paring back asset purchases in the US. High yield bonds, at the riskier end of the corporate bond spectrum, were the worst hit. Sovereign bonds across the world have tumbled with UK and US government bond yields higher across the curve and government bond yields of a number of emerging market issuers including Brazil reaching oneyear highs.

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Snapshot: Abenomics Japans agenda for change

Japans new Prime Minister, Shinzo Abe, has promised to transform his countrys fortunes with his three arrows. The Bank of Japan is aggressively buying long-dated government bonds to keep debt servicing costs low and the yen competitive. It will also buy equity and real estate funds, in the hope that rising asset prices and stronger balance sheets will boost confidence and economic activity. In the short term, the government will also provide a spending boost to the economy, but this is expected to reverse in 2014 and consumer taxes are also due to rise. This is because Abe aims to cut public borrowing to sustainable levels by 2020. Finally, the government plans to implement structural reforms such as deregulating industries though details are being kept vague until after the upper house elections on 21 July.
Figure 1. Japanese GDP and employment
3.0 2.0 1.0 0.0 -1.0 -2.0 96 97 98 99 00 01 02 GDP (2-year growth rate) (LHS) 03 0 05 06 07 08 09 10 11 Employment (1-year growth rate) (RHS) 12 13 1 2.0 1.0 0.0 -1.0 -2.0 -3.0

Source: Reuters, EcoWin

The aim is to rid Japan of its deflation malaise. Given interest rates cannot fall below zero, a return to positive inflation is expected to support activity by reducing real interest rates. If the Bank of Japan can peg long-term interest rates while nominal GDP (and therefore tax receipts) rises, this should also boost the public finances, particularly if pension increases can be kept below inflation. So far, the government has been unable to cut pensions despite falling prices.
Figure 2. Japanese wage inflation and Tokyo core inflation
1.5 0.5 -0.5 -1.5 -2.5 05 06 07 08 09 10 11 12 13 Wages (contractual cash, scheduled payments) Tokyo consumer prices (ex food and energy) Source: Reuters, EcoWin

In the short term, Abes agenda for change appears to be working. Employment is rising at the fatest rate since 2007. Given the working age population is declining, this means the labour market is tightening up. Reflecting this, wages are falling at a slower pace and businesses have promised to boost bonuses over the summer. Long-term challenges remain, particularly restoring the solvency of public finances in the wake of a falling working-age population and increasing number of retirees. But so far, so good.

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ECONOMIC AND INVESTMENT COMMENTARY

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UK forecast: Holiday season

UK economy Market participants forecasts High Low Median Last month median Legal & General Investment Management Price inflation (CPI) 2013 % 3.00 2.00 2.70 2.80 2.60 2014 % 2.80 1.40 2.40 2.50 2.30 GDP (growth) 2013 % 1.30 0.20 0.90 0.80 0.80 2014 % 2.60 0.90 1.60 1.50 1.40 10-year Gilt yields 2013 % 2.75 1.50 2.23 2.10 2.35 2014* % 3.25 1.50 2.40 2.30 2.75 Base rates 2013 % 0.50 0.25 0.50 0.50 0.50 2014* % 0.50 0.25 0.50 0.50 0.50 2013 1.61 1.41 1.49 1.49 n/a $/ 2014 1.62 1.38 1.52 1.51 n/a 2013 0.91 0.78 0.84 0.85 n/a / 2014 0.91 0.76 0.85 0.84 n/a

Source: Bloomberg L.P . and LGIM estimates *Consensus forecasts are for end of Q2 2014 The forecasts above are taken from Bloomberg and represent the views of between 2040 different market participants (depending on the economic variable). The high and low figures shown above represent the highest/lowest single forecast from the sample. The median number takes the middle estimate from the entire sample.

As the northern hemisphere moves into peak summer months, the pace of regular life slows somewhat. Politicians call it the silly season. For footballers its the off-season. Even Fundamentals takes a month off to draw fresh inspiration. But not everyone has an easy time. After seven months of anticipation, a Canadian is starting his new job in central London. No ordinary Canadian. No ordinary job. Mark Carney is the new Governor of the Bank of England. What will he do? What is he like? Some point to evidence of his being a dove. Others are equally adamant that hes a hawk. Is there anything really worth being hawkish or doveish about? Inflation ticked higher in May and is likely to rise further in June reflecting falls in commodity prices this time last year. But most expect the inflation rate to ease in the second half of this year and into 2014. We have recently pushed our inflation forecast down slightly to reflect our research showing that unit labour costs are moderating. After allowing for the 0.3% effect of tuition fees on inflation until late 2015, inflation may effectively be at target by the end of next year. Little need for central bank action here. Looking at growth, labour market strength has decreased somewhat after a phenomenally strong first half last year. This makes us a bit more cautious about consumer spending, but UK credit conditions are improving modestly. RICS survey data point to resilience in the housing market. Business sentiment is picking up and we expect investment to increase. As weve said before, it isnt a boom, but the UK economy is growing. So little need for central bank action here. However, the Governor of the Bank of England can do more than oversee changes in interest rates or quantitative easing. He can signal changes in attitude or how things will be done. We think there is a good chance that Mr Carney will want to provide markets with more effective communication on future changes in policy something he did at the Bank of Canada. In the short term, this means that Mr Carney could actually make quite an impact; not only could he announce that hes doing nothing for now, but more importantly that he intends to do nothing for some time perhaps even a year or more. As a long-term philosophy, we think that providing more guidance is a good idea. Mr Carneys reputation suggests this wont be the only good idea he has.
For further information on Fundamentals, or for additional copies, please contact katie.robertson@lgim.com For all IFA enquiries or for additional copies, please call 0845 273 0008 or email cst@landg.com For an electronic version of this newsletter and previous versions please go to our website http://www.lgim.com/knowledge/fundamentals Important Notice This document is designed for our corporate clients and for the use of professional advisers and agents of Legal & General. No responsibility can be accepted by Legal & General Investment Management or contributors as a result of articles contained in this publication. Specific advice should be taken when dealing with specific situations. The views expressed in Fundamentals by any contributor are not necessarily those of Legal & General Investment Management and Legal & General Investment Management may or may not have acted upon them and past performance is not a guide to future performance. FTSE, FT-SE, Footsie, FTSE4Good and techMARK are trade marks jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE International Limited (FTSE) under licence. All-World, All-Share and All-Small are trademarks of FTSE. 2013 Legal & General Investment Management Limited. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers. Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA www.lgim.com Authorised and regulated by the Financial Conduct Authority.
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