Weekly commentary from Wells Fargo Investment Institute on international topics in the news.
Peter Donisanu, Investment Strategy Analyst
Is Eurozone Inflation Signaling a Policy Shift?
- As Eurozone inflation moves higher, some investors have asked whether the European Central Bank (ECB) may signal an end to its asset-purchase program sooner rather than later.
- While data reports this week showed that headline Eurozone inflation accelerated in April, we believe that the increase may not necessarily signal a policy shift from the ECB.
What it may mean for investors
- We believe that the ECB’s continued easy-money policies are likely to be supportive of European stocks, but weigh on developed-market bonds (which include Eurozone country bonds) and the euro currency.
On Wednesday, the European Union’s statistical agency, Eurostat, published its final report on Eurozone consumer price inflation for the month of April. This latest report showed that prices in the currency bloc increased 1.9 percent on a year-over-year basis, one of their fastest gains in four years. Some investors have asked whether rising inflation rates in the currency bloc, coupled with improving economic prospects, could open the ECB to discussions on tapering its asset-purchase program and to raising rates sooner rather than later.1
We believe that the increased likelihood of asset tapering or rate increases by the ECB in the near term is low. We expect policymakers to remain committed to easy-money policies for a few key reasons. First, as we discussed in our February 3, 2017, International Briefing report, the goal of the ECB’s easy-money policies is to prop up medium-term inflation trends.2 While this week’s data release suggests an upward swing in consumer-price inflation, this trend is a relatively new development (as Chart 1 illustrates). As a result, we expect policymakers to let inflation overshoot the central bank’s target for some time before tapering its $65 billion per month asset-purchase program.
Second, while the sharp rebound in headline inflation has been notable, its persistence may be transitory and not necessarily reflective of the pace of broader inflationary trends. We believe that the sudden rise in consumer prices is attributable, in part, to an energy-sector upswing from last year’s low price levels. More recently, energy prices have moved sideways and, in some cases, trended lower from where they were 12 months ago. What this means is that, as time moves forward, lower year-over-year gains in energy prices are likely to have a more muted influence on the energy components of headline inflation—putting downward pressure on the inflationary trend.
Finally, longer-term inflation catalysts, namely in the Eurozone labor market, remain subdued. Eurozone unemployment has fallen from a peak of 12.1 percent in 2013 to 9.5 percent in April of this year, even as more individuals return to the labor force. A falling rate of unemployed workers should put upward pressure on wage growth. Yet, wage growth has been subdued, considering that today’s Eurozone jobless rate remains above a pre-crisis low of 7.3 percent and renewed entrants into the labor force have increased the available supply of labor for employers. We expect broader inflationary pressures to rise as labor-market conditions tighten, but data suggests that this development may take many more months to play out in the Eurozone.
While data reports this week showed that headline inflation has accelerated in the Eurozone, we believe that this increase may not necessarily signal a policy shift from the ECB. The recovery in inflation is a near-term development and likely influenced by a transitory rebound in energy prices. Further, longer-term drivers of inflation, such as wage growth, remain subdued—as slack in the Eurozone labor market remains. Nevertheless, we maintain our view that a modest inflationary recovery is underway in the currency bloc, and we expect prices to move modestly higher through year-end 2017. As a result, we expect the ECB to refrain from discussing “exit strategies” for its asset-purchase program until broad inflation measures demonstrate the potential for a sustained trend in rising prices for a period greater than one year.
For now, we believe that the ECB’s easy-money policies are likely to underpin credit creation in the currency bloc—which has helped to fuel the Eurozone economy. The rebound in economic growth is translating into a corporate-earnings recovery which we believe to be supportive of Eurozone stocks. Nonetheless, we maintain our neutral investment rating on European stocks (including Eurozone equities) for the time being. While market risks related to European elections have faded, our neutral guidance reflects post-election valuation concerns. We maintain a favorable rating on Pacific-region stocks within a broader allocation to developed market equities.
For bonds, we expect that the combination of continued easy-money policies from the ECB and higher interest rates in the U.S. this year will lead to an increasing spread between yields on U.S. Treasury securities and Eurozone government-bond yields. Our underweight rating on the international developed-market bond class reflects this expectation. We prefer allocations to U.S. fixed-income markets, notably in intermediate term investment-grade bonds. As for the euro, we believe that the current rally versus the U.S. dollar is likely to fade through year-end 2017, reflecting widening interest-rate differentials as the Federal Reserve continues down a path of raising its key policy rate.
1 Please see our March 10, 2017, International Briefing Report: “Does the Eurozone Recovery Still Have Legs?” for more information.
2 Please see our: International Briefing report titled: “Are the ECB’s Asset Purchases Coming to an End?” for more information.
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