European Central Bank Underestimating Deflation: Credit Suisse

European Central Bank

European Central Bank is under fire for failing to aggressively counter deflation in Europe. In fact, the ECB is underestimating the potential for deflation, Credit Suisse analysts claimed in a 50-page equity research report released Tuesday.

Europe’s current inflation rate of 0.8 percent is far below its target of 2 percent. However, the ECB did not lower its benchmark interest rate as the market expected this past Thursday and left it at 0.25 percent. Market watchers worry that Europe will be the next Japan. The island nation has suffered from long-term deflation because its central bank failed to stoke inflation with its monetary policies.

“After the ECB’s hawkish inflation forecast last week, we think the ECB is underestimating the disinflationary pressures in the euro area, and will be forced to become more accommodative as inflation continues to surprise on the downside,” Andrew Garthwaite, a research analyst at Credit Suisse and his colleagues, wrote.

Credit Suisse says the European Central Bank fails to see that the euro zone is more likely experience deflation than inflation for myriad reasons. It is underestimating the fact that unemployment in the eurozone remains very high at 12 percent. That in turn reduces wages in the industrial and service sectors. Corporations and governments are lowering labor costs by cutting social security contributions in addition to letting temporary workers replace full-time workers for up to two years. Commodity prices are falling on worries that China’s economy is slowing.

“The Chinese currency has recently fallen to a four-month low.” Credit Suisse stated. “In our view, reminbi depreciation and a Chinese slowdown are clearly deflationary because it raises the prospect that the Chinese will compete more aggressively in export markets.”

The ECB will likely engage in quantitative easing, or QE, if China suffers an economic shock, the euro appreciates to $1.50, or if the eurozone Purchasing Manager’s Index, PMI, reading fell below 50, the report stated. Readings above 50 show business expansion and readings below the threshold means contraction.

Business investment relative to gross domestic product is at a 20-year low. Bank lending is still tight but getting easier. The European Commission projects the euro zone economy will grow by 1.2 percent this year.

Credit Suisse recommends investors overweight European stocks because of their superior earnings per share growth potential compared with the U.S. European earnings are seen climbing by 38 percent over the next three years while U.S. earnings are projected to grow 24 percent over the same period. Corporate earnings momentum is starting to improve and manufacturing orders indicate an increase in corporate earnings.

“The Continental European equity market, excluding financials, is still trading more than one standard deviation cheap on price-to-book relative to global markets,” Credit Suisse wrote. “Price-to-earnings are marginally above their norm. This makes Europe an earnings-rebound story… adjusting for the differential in earnings upside, European equities are trading on an 18 percent P/E discount to U.S. equities.”

“We think the difference in earnings growth rates could even be larger, given that the 12-month forward earnings per share (EPS) in the Euro area is close to 2008 lows and is still 32 percent below its previous peak, while the U.S. 12-month forward EPS is double its 2008 low and about 20 percent above its previous peak,” Credit Suisse added.

From a contrarian perspective, Europe presents a good buying as buy recommendations on European stocks are still at a 10-year low. Investor appetite for risk is below average. Credit Suisse recommends overweighting banks as estimates are overly pessimistic. Banks tend outperform the stock market the more economic uncertainty increases.

“Banks are the largest cyclical play on European domestic demand and we expect domestic demand to continue recovering,” the report stated. “Bank deleveraging is already at an (advanced) stage, with capital and reserves for Euro-area banks at a 20-year high of 7.5 percent of assets, according to ECB data. Banks are enjoying strong earnings breadth relative to the rest of the market, with relative earnings revisions close to an eight-year high.”

In addition, if ECB engages in QE by buying bonds, banks should benefit. “This would likely lead to an improvement in Euro-area liquidity conditions, pushing credit spreads further towards their historical troughs. European banks would be the major beneficiaries of such a move, given that lower credit spreads would mean better asset quality and low default risks. In fact, banks tend to be among the best-performing sectors in periods of falling credit spreads.”

The dollar will likely appreciate against the euro, which would support European exports. If the euro appreciates to more than $1.45, the ECB will be forced to take action.

“Stronger U.S. economic momentum, upside potential to U.S. two-year note yields and a peaking in the European current account eventually favor a stronger dollar,” Credit Suisse’s report stated.

Domestic consumer demand is recovering as household savings rates in most of Europe hover at double digits.”The economic recovery in the Euro-area looks much more robust than it did at any point over the past three years,” Credit Suisse stated.

The European Central Bank currently estimates that inflation will reach 1.7 percent in two years and 1.9 percent five years out. It expects Europe to experience a prolong period of inflation market expected. It did not flush money into the financial system as the market expected. Credit Suisse believes it may have to given that it is underestimating deflation.

By Trang Ho

Credit Suisse (report)
Financial Times
The Wall Street Journal
European Central Bank
BBC News

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