In 1996-97, Japan’s inflation rate was creeping down toward zero, but was not yet below it. The same is happening in the euro area now – we expect Friday’s headline flash CPI reading to be 0.4% y/y, near its record low (0.3%). In 1997, there were signs of Japanese inflation expectations “de-anchoring” over short horizons, even as longer-term inflation expectations remained well anchored.
One of the key trends in the euro area this year has been a de-anchoring of both short and longer-dated inflation expectations (Figure 1). Then, as now, typical measures of central bank policy appropriateness, such as a Taylor rule, were beginning to send signals that the policy stances of the central banks were becoming too tight. Perhaps most important, in 1997 the prospect of 15 years of deflation in Japan was still considered unthinkable by most, just as it is unthinkable for the euro area today (including by us).
Another key message from our deflation analysis was that the next 1-2 years would likely be crucial for European policymakers. Although this idea extends beyond the ECB, we believed that, ultimately, the central bank would probably have to play a central role if euro area deflation risks did become more acute, as they now have done. In our view, the ECB’s response has been good, if not exceptional. Importantly, the ECB has achieved two things that the BOJ did not in the late 1990s: a (modestly) weaker currency and negative longer-dated yields (Figure 2). In Japan’s case, negative longer-dated yields were achieved only in 2013, thanks to the BOJ’s aggressive QQE policy. Encouragingly, the recent rise in euro real yields and the trade-weighted euro were met by comments last week from ECB President Mario Draghi that there was scope for expanding its current balance sheet expansion policies. Indeed, as the year has progressed, President Draghi has gone out of his way to emphasize that the ECB would get ahead of the deflation risks to avoid Japan’s experience (see ECB – worried about excessively low inflation expectations). Still, inflation expectations remain near the cycle lows and, so far, ECB policies have done little to help the persistent underperformance of European equities.
What is at stake? We’d argue quite a lot. Despite important differences between the euro area today and Japan in the 1990s, there is one striking similarity that should matter to investors: the path of equity markets. Indeed, the similarities between Japanese and European equities look ominous, especially for those peripheral European markets that have already experienced deflation, or something close to it .
Adding the US equity market experience makes the stakes even clearer. In all three cases, a significant financial shock raised fears of economic deflation. In the US, these fears ebbed quickly, at last partly driven by decisive monetary action from the Federal Reserve. In Japan, deflation fears turned into reality and the equity market posted a further 50% decline after the economy fell into deflation. By contrast, US equities are now at record highs.
Japanese equities, though, were trading at more than 35x price to earnings as the economy fell into persistent deflation. The bubble-like multiples reflected still-high expectations and a notable savings glut. But the multiple de-rating as deflation took hold exacerbated weakness in Japanese equities. European equity multiples are not nearly as extended and are already in line with those of Japan, which has already experienced years of deflation.
Although household wealth in Europe and Japan is not as heavily weighted toward the equity market as in the US, the fall in Japanese equities likely had some impact on Japanese consumption via the wealth effect, and thus on inflation; the potential drag in Europe from a fallout in equities should therefore be less than in Japan, given much different starting multiples.
If the ECB does manage to alter the path of euro area deflation risks, we think European equities could benefit most, as bond yields have already fallen to near deflation-like levels and European equity multiples seemingly reflect the risk. Against this, if the ECB disappoints, we see further downside risk to European equities, although it is not clear that European equities should follow the same path as Japan given very different starting valuations.
Ultimately, however, our main concern would be peripheral debt. These bonds are clearly pricing in some expectation of ECB action already and, given their longer-term debt sustainability dynamics, it is hard to imagine spreads remaining tight if the ECB fails to deliver decisive policy action in the coming months.