Europe’s battle against deflation, the market impact

November 13, 2013

Last week, Counterparties rounded-up the growing fears of deflation in Europe, as the European Central Bank’s surprise rate cut to stave off that threat.  Today, Reuters has more:

The threat of deflation in the euro zone could reverse a major investment trend of 2013, drawing funds out of stocks and into government bonds and cash.

Europe is still some way from a negative inflation rate, let alone a Japanese-style deflationary spiral – the policymakers’ nightmare in which falling prices weaken demand, leading to wage cuts and even lower prices.

But a warning light is already flashing, with euro zone inflation registering a shock drop last month that prompted an interest rate cut.

Deflation, or a widespread drop in prices, can be terrible for labor markets, can discourage investment, and can make debtors fall deeper into debt — Paul Krugman has more hereHere’s what euro zone inflation and equities currently look like:

Reuters explains why more disinflation — or inflation that rises too slowly — could be bad for the market:

Deflation alone is not seen as an outright negative for equities, which can still rise if there is moderate growth.

But in such an environment, financial stocks tend to underperform because deflation increases a borrower’s real debt burden, contributing to higher non-performing loans and lower net interest margins for banks as the gap between short- and long-term interest rates narrows.

“Markets will be focusing on assets that provide nominal guaranteed returns such as government bonds. You would want to be aware of risks in equities, in particular in financials,” Bill O’Neill chief UK investment strategist at UBS Wealth Management tells Reuters.

“There is definitely a whiff of disinflation again taking hold globally,” Robert Sinche, global strategist at Pierpont Securities Holdings told Bloomberg.

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