Market & Investment Insights
Europe seeks to fight off
deflation
Article Highlights:
• Europe is facing the risk of deflation, which can have both positive and
negative economic impacts.
• Amid a weak economy and low inflation, the European Central Bank is
mounting a stimulus campaign to drive interest rates down, spur faster
economic growth and increase the rate of inflation.
• Deflation benefits bond investors, while inflation is better for the stock
market. Stocks are likely to benefit as the stimulus program strengthens the
economy, and to outperform bonds in the year ahead.
Since the 2008-2009 recession, Europe’s economy has experienced a prolonged
period of slow, and sometimes negative, growth. New warning signs emerged
recently when the annual inflation rate in the eurozone — the 19 countries that
use the euro as their common currency — fell to -0.2% in December 2014 and to 0.6% in January 2015, raising concerns that the region was poised to sink back
into its third recession in the past five years.
But it’s important to understand the nature of inflation and deflation to know what
this drop really means. This decline was in what is called “headline inflation” – a
measure that includes oil and food prices, which are vulnerable to short-term
fluctuations. The better measure to examine is “core inflation,” which excludes
these volatile categories and thus offers a more accurate picture of long-term
trends.
In Europe, core inflation is low but still positive (0.5% in January compared to an
average of 1.6% since the launch of the euro in 1999). There are, nonetheless,
countries in the eurozone that are experiencing deflation: Greece and Spain, for
instance, saw prices fall for much of 2014. Europe’s response to the risk of
deflation will have a substantial impact for investors in the coming year.
Europe seeks to fight off deflation
Some countries in the Eurozone are already experiencing deflation
Deflation and the economy
Deflation can have both positive and negative economic impacts. On the plus side,
few consumers will complain about falling gas prices or a lower phone bill. There is a
risk that wages will fall as well, but as long as prices fall more quickly, workers are
still better off. However, falling prices can encourage consumers to put off
purchases in hopes of even lower prices, thus weakening demand and slowing
economic activity.
While deflation doesn’t necessarily prevent economic growth — Japan’s economy
expanded for years as prices were falling, while Italy’s economy contracted even
though prices were rising — it is often a sign of economic weakness, signaling that
there is not enough demand to keep prices from declining.
Europe seeks to fight off deflation
Economic stimulus in Europe
To counter the weakening of the eurozone economy, the European Central Bank
(ECB) announced a massive new economic stimulus plan in January aimed at
driving already low interest rates even lower and spurring new demand. The bank
plans to flood the eurozone economy with cash, buying 60 billion euros worth of
government bonds every month in hopes of strengthening the economy to the point
where inflation gets close to, but below, 2%.
In view of the ECB’s stimulus package, together with economic reforms being
pursued in countries like Greece and Spain, Europe will probably be able to avoid
entrenched deflation. The stimulus plan should have the effect of driving down
interest rates and boosting demand (and prices) for goods and services. It should
also serve to weaken the euro, which will increase the cost of imports. The euro has
already fallen by 20% versus the dollar since May 2014, and it could fall a further
4%-5% more in 2015.
European stocks likely to outperform bonds in 2015
Europe’s ability to ward off deflation will have a significant impact on the market. In
general, bond investors tend to benefit from deflation, since the spending power of
their investment is rising because the cost of goods and services is falling. On the
other hand, stock market investors do better during periods of inflation, because the
businesses they invest in are selling their goods and services for higher prices.
European bonds delivered remarkably strong performance in 2014, with the
benchmark Barclays Euro Aggregate index — which measures the performance of
many different types of bonds — returning 11.1%, compared with just a 5.1% total
return in local currency terms for European stocks (as represented by the MSCI
EMU Index). While the stimulus program will provide support for bond prices in the
year ahead, bond returns will likely be lower in 2015.
On the other hand, as demand strengthens and inflation picks up, the European
stock market is likely to outperform bonds in the year ahead. The modestly
improving economic outlook should provide a boost, and current valuations are
attractive relative to the U.S. market. Eurozone stocks, as measured by the MSCI
EMU index, are trading at about 13.5-times future annual earnings, while the S&P
500 trades at about 16.5 times earnings.
Europe seeks to fight off deflation
Managing the risks of deflation
Like inflation, deflation – and its implication of slowing economic growth rates –
could have a significant impact on your investment portfolio. To help mitigate the
risks posed by deflation, we recommend a widely diversified portfolio that includes
allocations to fixed-income and equity securities across geographies, based on your
investment objectives, time horizon, and tolerance for risk. If you have questions
about how deflation could affect the value of your holdings or your expected
investment income, discuss with your TIAA-CREF advisor whether your portfolio is
positioned to weather deflation and other economic changes over the long term.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF
group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management,
LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc. is a registered investment
advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no
guarantee of future results.
Please note that equity and fixed income investing involve risk.
Please note the equity and fixed income index performance quoted above does not reflect investment fees or
transaction costs. It is not possible to invest in an index.
Please note the market and currency forecasts above concern asset classes only, and do not reflect the experience of any product or service
offered by TIAA-CREF. These forecasts are for informational purposes only and should not be considered investment advice or constitute a
recommendation to purchase or sell securities. Market forecasts are subject to uncertainty and may change based on varying market conditions,
political and economic developments.
This material is prepared by TIAA-CREF Asset Management and the views expressed may change in response to changing economic and market
conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a
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