The Longview

PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES ON THE LAST PAGE.

Imagination is a poor substitute for experienceHavelock Ellis

A finite world can support only a finite population;therefore, population growth must eventually equal zeroGarrett Hardin

Macroeconomic policy can never be devoid of politics:it involves fundamental trade-offs and affects differentgroups differentlyJoseph Stiglitz

Life is the art of drawing without an eraserJohn W. Gardner

Ageings alright, better than the alternative, which is notbeing hereGeorge H. W. Bush

Nobody goes there anymore. It's too crowdedYogi Berra

Published by Barclays13 February 2014ISBN 978-0-9570088-2-3100

Barclays | Equity Gilt Study

13 February 2014 1

EQUITY GILT STUDY 2014

59th Edition The Equity Gilt Study has been published continuously since 1956, providing data, analysis and commentary on long-term asset returns in the UK and US. This publication contains a uniquely long and consistent database: the UK data go back to 1899, while the US data provided by the Centre for Research in Security Prices at the University of Chicago begin in 1925. We also use the Equity Gilt Study as an opportunity to analyze medium- to long-term market trends.

Chapter 1 considers whether the eurozone is moving toward Japan-style deflation. Our assessment is that the verdict is still out, but the risks are higher than market pricing or policymakers suggest. ECB policy is starting to look too tight and bank lending has yet to improve. True, the asset price shock, demographic dynamics and exchange-rate trend are less acute than they were in Japan, but tight fiscal policy, ongoing internal devaluations and global disinflationary pressures are adding to the eurozones deflation risks.

Chapter 2 introduces a new valuation metric for stock indices that accounts for differences in sectoral composition across countries. A country whose equity market contains a high proportion of companies in sectors that attract low multiples may appear more inexpensive than it would be if it were analyzed on a sector-by-sector basis. Applying the sector- and cyclically-adjusted PE ratio (SCAPE) renders US equity valuations more attractive relative to other countries, which tend to have a larger share of companies in the financial sector and a smaller share of technology firms.

Chapter 3 looks at the economic implications of demographic change. In China and much of the economically advanced world, population growth is decelerating and dependency ratios are rising. These dynamics are set to stress fiscal sustainability in advanced and emerging markets and could complicate the debt dynamics of southern Europe and rebalancing in China. They could also tilt the terms of trade in favour of labour income relative to profits in the US. But we do not expect these dynamics to create strong deflationary tendencies.

Chapter 4 considers the cost of evolving bank regulation which has mandated capital structure changes to boost industry safety. It argues that regulations aimed at shifting the balance between sources of wholesale funding should not increase the average cost of funding for banks. However, reforms that raise capital requirements as a percentage of the balance sheet could constrain the ability of large banks to interact efficiently with clients, creating a cost that would be passed on to various stakeholders. We suggest that these costs be weighed against the safety and soundness benefits.

Chapter 5 focuses on the future of US housing finance, which continues to be explicitly or implicitly guaranteed by the US government. We estimate that $400-450bn of private capital will be needed to transfer the credit risk of all government-guaranteed mortgages to the private sector. Thus, a complete government retreat will need to be orderly and, in our view, spread over at least 10-15 years.

Chapter 6 examines the investment implications for economies shifting into reflation or deflation, with an emphasis on Japan and Europe.

We sincerely hope that you find the data and the essays interesting and enlightening, as well as useful inputs to your investment decisions.

Larry Kantor Head of Research, Barclays

Website: Equity Gilt Study on www.barclays.com E-mail: [email protected]


13 February 2014 2

CONTENTS

Chapter 1 Japan-style deflation in Europe getting harder to dismiss 4 Comparing the eurozone with Japan at a similar stage in its deflationary episode suggests deflation risks in the eurozone are not meaningfully lower. Although not our central scenario, we think the risks of eurozone deflation are higher than market pricing or policymaker rhetoric currently imply. The next year or two will be crucial to reaching a verdict: ECB policy looks increasingly too tight and bank lending has yet to improve, despite some balance sheet repair. Were deflation to materialize, the asset allocation implications would be meaningful.

Chapter 2 Introducing the SCAPE: Why US equities are less expensive than they seem 30 Comparisons of equity-market valuations across countries are complicated by substantial differences in sectoral composition. We propose an approach to adjust for the measurement distortion created by these differences, and a valuation metric that we think better isolates country or regional factors from compositional influences. With a few exceptions, compositional effects make non-US equity markets appear cheaper than they would seem after accounting for the effect of sectoral composition. Our measure of the sector- and cyclically-adjusted PE ratio (SCAPE) suggests that most non-US markets are still cheaper than the US. But the gap between the US and the rest of the world is in general meaningfully smaller than the unadjusted CAPE suggests.

Chapter 3 Economic implications of demographic change 38 China and much of the economically advanced world face an important inflection point: population growth is decelerating and turning negative. Moreover, dependency ratios are rising, after a long period of stability or decline. We highlight four ways in which this trend could affect the next decade: 1) complicate the task of fiscal consolidation, mainly through a rise in age-related public spending; 2) support the process of economic rebalancing in China while magnifying the challenge of shifting the economy away from its investment-led development pattern; 3) complicate the debt dynamics of southern Europe, where population growth is poised to turn negative; and 4) potentially tilt the terms of trade in favour of labour income relative to profits in the US. However, we do not think demographics will be the decisive influence on the balance between inflationary and deflationary forces in the decade to come.

Chapter 4 The cost of evolving bank regulation 51 Since the financial crisis, academics, politicians, and regulators have proposed reforms aimed at making the banking sector more stable. Often, these rules have sought to boost industry safety by mandating capital structure changes. Many in the business world have argued that these reforms are costly. Our analysis suggests that some reforms are costly. We do not see reforms aimed at shifting the mix between sources of wholesale funding as costly. However, we believe that raising capital requirements would constrict the ability of most large banks to interact with clients efficiently, creating a cost that would be passed on to various stakeholders. Any future rules must therefore balance these costs against the safety and soundness benefits.


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Chapter 5 The future of US housing finance 70 Even as the US housing market has had a remarkable resurgence in the past few years, housing finance has not. The extent of government involvement in mortgage lending poses unacceptable risks to the taxpayer. Among existing legislative proposals, the Corker-Warner bill looks to be the most promising. It requires the first-loss piece to be backed by sufficient private capital to deal with stressful scenarios but also provides an explicit government backstop under extraordinary circumstances. We estimate that $400-450bn of private capital is needed to absorb the credit risk of all $4-4.5trn in government-guaranteed GSE mortgages, assuming a 10% first-loss piece. The private markets cannot raise this amount easily. In our view, a government retreat will need to be spread over at least 10-15 years, not the five years proposed by Corker-Warner.

Chapter 6 Shifting inflation landscapes: Implications for Japan and Europe 90 We examine the relative impact of reflation and deflation on financial markets, and the implication for regional asset allocation. We compute the optimal allocations across different inflation regimes and find that if Japan continues to transition out of deflation, the impact is relatively clear and equities are likely to outperform fixed income. For Europe, the story seems more nuanced. Here we find that the investment cycle plays an important role in determining how to allocate if we slip into deflation.

Chapter 7 UK asset returns since 1899 97 2013 can be described as a year of two halves: pre- and post-tapering fears. Fed Chairman Ben Bernankes speech on 22 May signalled the inflexion point for UK and US bond markets. Gilts sold off in synch with US Treasuries. Annual real bond returns of -9.6% in the UK are the worst since the bond rout of 1994, when gilts sold off 14% in real terms. Equity markets performed well despite the turbulence introduced by monetary policy uncertainty. The FTSE All-Share initially sold off 11% in response to tapering fears, before recovering to end the year up 17% in terms of nominal capital returns.

Chapter 8 US asset returns since 1925 102 Equities were the best-performing assets of 2013, producing a c.29% real total return, despite a turbulent path as investors digested news of monetary policy normalisation by the Fed. Returns on Treasuries and TIPS collapsed in 2013, following Fed Chairman Ben Bernankes speech on 22 May which first mentioned the prospect of tapering asset purchases. 10-year yields rose from near historical lows of 1.6% to end the year above 3%. Real total returns on Treasuries fell 13% in 2013, compared with a 2% real total return in 2012.

Chapter 9 Barclays Indices 106 We calculate three indices: changes in the capital value of each asset class; changes to income from these investments; and a combined measure of the overall return, on the assumption that all income is reinvested.

Chapter 10 Total investment returns 129 We present a series of tables showing the performance of equity and fixed-interest investments over any period of years since December 1899.


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CHAPTER 1

Japan-style deflation in Europe getting harder to dismiss Comparing the eurozone with Japan at a similar stage in its deflationary episode

suggests deflation risks in the eurozone are not meaningfully lower. Although not our central scenario, we think the risks of eurozone deflation are higher than market pricing or policymaker rhetoric currently imply.

Although the asset price shock, demographics and exchange-rate trend are less acute than they were in Japan, tight fiscal policy, ongoing internal devaluations and global disinflationary pressures all add to the eurozones deflation risks.

The next year or two will be crucial to reaching a verdict: ECB policy looks increasingly too tight and bank lending has yet to improve, despite some balance sheet repair.

Longer-term inflation expectations in the eurozone are anchored but, similar to Japan in the mid-1990s, shorter-dated inflation expectations are declining.

At the country level, how and when France and Italy seek to restore competitiveness will be key to whether region-wide deflation develops.

Were deflation to materialize, the asset allocation implications would be meaningful: the current consensus view that eurozone equities are cheap and yields too low, would be challenged; further upside potential in bank equities would be limited; risks to the euro would tilt up; and peripheral debt sustainability, already tenuous, would be challenged further.

For many years, Japan's persistent deflation trend was viewed as an anomaly among major developed economies. Although Japans deflationary period generated volumes of academic research, such a situation was not viewed as a realistic threat for other major economies. The 2008 financial crisis changed this perspective. At first, fears centred on the US, but as the US economy has begun to recover, concerns about US deflation have ebbed a little. Still, it is notable that after five years of unprecedented policy easing, policy rates at zero and a significant decline in the rate of unemployment, the core Personal Consumption Expenditure (PCE) inflation rate is still just above 1% and has remained well below the Federal Reserves 2% target. In 2011 we looked at whether the US was at risk of a Japan-style deflation cycle and judged the risks as low1. It is still early to argue that the US is out of the woods on the deflation front, but we are confident that our view is on track.

These days, concerns about a prolonged deflationary episode have shifted to the euro area. At the end of 2013, core inflation in the eurozone touched a record low of 0.7%, with several southern euro countries, including Greece, posting outright deflation. Members of the European Central Bank (ECB) are now taking their turn to defend their policies and strongly contrast current eurozone conditions with Japans experience of the past 20 years. In public, at least, the ECB sees little risk of Japanese-style deflation taking hold in the euro area.

In this chapter, we examine whether Europe is at risk of a Japanese-style deflationary cycle and explore what such a period might mean for asset allocation in European markets. First, we review Japans deflationary experience and its likely causes. Second, we compare the relevant factors of Japans deflation experience with the eurozone today. Third, we highlight three important factors that make the eurozone different from Japan. Fourth, we assess the likelihood that eurozone deflationary risks will materialize. Last, we explore the

1 What's the difference between Japan and the US? 31 August 2011.

Jim McCormick

+44 (0)20 7773 7699

[email protected]

Philippe Gudin

+33 1 4458 3264

[email protected]

Marvin Barth

+44 (0)20 3134 3355

[email protected]

Ian Scott

+ 44 (0)20 3134 7668

[email protected]

Barclays, London

Francois Cabau

+44 (0)20 3134 3592

[email protected]


13 February 2014 5

potential effects on eurozone asset prices and asset allocation decisions were the eurozone to experience a prolonged period of sub-par inflation or outright deflation.

Our assessment is that the risks of a region-wide, deflationary period are significant, and certainly bigger than what is currently priced into financial markets or being publically acknowledged by eurozone policymakers. In any case, the likelihood of a prolonged period of falling price levels in at least several eurozone countries looks high.

Understanding Japans deflationary era Although Japan was in a state of falling prices from the mid-1990s until very recently (Figure 1), two other points are key to understanding this period: Japan first experienced falling consumer prices some six years after the bursting of the asset bubble in December 1989. In other words, although the bursting of Japans bubble was almost certainly an important driver of Japans deflationary cycle (and a key inflexion point), it was not the only cause and possibly not the main cause. Second, within this deflationary state, Japans economic performance was not all bad. On some measures, including GDP per worker, Japans economic performance in the past decade has been impressive2. Now, after nearly 15 years of uninterrupted price declines, Japan is today enjoying its first credible period of positive inflation since the late 1980s (without the help of a VAT tax increase). In other words, Japan may well provide lessons not only on how an economy can enter and remain in deflation for such a long period, but also on how it may exit deflation (although it is probably a little early to draw any lessons on exit).

Taken together, these remarks suggest that Japans deflationary era was marked by three distinct periods. During the first period (1990-2002), Japan faced an almost uninterrupted series of economic shocks and dislocations. The first, and arguably most severe, of these was the collapse of the bubble economy of the 1980s, which was compounded by the almost simultaneous demographic transition from a growing to a shrinking population. By 1996, the labour market seemed to be stabilizing, but the economy was soon undermined again, this time by the Asian financial crisis. In 1999, the labour market once again showed signs of steadying, but the economy was then stymied by the collapse of the US equity bubble. In other words, the 1990s might be viewed as a series of home-grown and external shocks. Addressed by inadequate but at the time perfectly understandable policies, these shocks left Japans economy with a huge negative output gap and very low inflation, which finally gave way to deflation in the late 1990s (Figure 2).

2 Is Deflation a trap? Revisiting the Japanese experience Global Macro Daily, 14 January 2014

Japan may provide lessons not only on how an economy can enter and remain in deflation for such a long time, but also on how it may exit deflation

FIGURE 1 Evolution of core CPI* in Japan and eurozone

FIGURE 2 Evolution of Japan and eurozone output gaps

Source: Barclays Research, Haver Analytics, OECD; * core CPI excludes energy and fresh food prices (Japans own core measure only excludes fresh food)

Source: Barclays Research, Haver Analytics, OECD

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The second period, from 2002 until late 2012, was markedly different. This decade included its share of shocks, including the 2008 US financial crisis and the 2011 Tohoku earthquake. But in between these shocks, Japan enjoyed a period of sustained economic and labour market recovery, at least as measured by the unemployment rate. The labour-market recovery was associated with an easing of deflationary pressures but the cumulative effects of the 1990s shocks and inadequate policy response meant the economy was unable to exit deflation in any meaningful way until 2013. This second period was when deflation expectations became more de-anchored and intermittent economic recoveries were too shallow to alter the trend.

The third period began in early 2013 with the launch of Abenomics (economic policies advocated by Prime Minister Shinzo Abe) and what looks to be the emergence from 15 years of nearly uninterrupted falling prices. Although the focus of this chapter is on what we can learn from Japans entry into deflation (and the persistence of this deflation), the success (or failure) of Abenomics will likely provide further lessons for policymakers and markets in the coming years.

The likely causes of deflation in Japan There is a great deal of literature on the causes of Japans deflation, much of which we will draw upon here (see bibliography at the end of this chapter). We divide the likely causes into five groups: 1) a series of (mainly) financial shocks beginning with the bursting of the 1980s bubble; 2) negative demographics; 3) policy responses; 4) the de-anchoring of inflation expectations; and 5) disinflationary pressures from China and other Asian economies.

Series of shocks. The bursting of the 1980s bubble was followed by the Asian financial crisis, the US equity bubble, the Lehman Brothers collapse, and the Tohoku earthquake in 2011. During that period, Japanese equities fell by nearly 80% and today remain nearly 60% below their 1989 peak. Meanwhile, land prices are still 60% below their 1991 peak. In terms of the economic impact of these shocks, a look at Japans output gap over time is instructive. Each shock was followed by a shallow recovery, but subsequent shocks consistently left the economy more prone to deflation (Figure 2). Although the exchange rate is only loosely linked to the financial collapse, for the purposes of comparing the eurozone with Japan, it is also worth noting that the real effective yen exchange rate rose 65% between early 1990 (just after the financial collapse) and mid-1995 (just as Japan was starting to flirt with deflation).

Demographics. At about the same time that Japans asset price bubble was bursting, Japans demographic picture took a turn for the worse. From its peak in 1995, Japans working age population (WAP) has fallen by nearly 10%, or about 0.5% per year. There has been plenty of debate on how big a role this demographic drag has played in Japans deflationary trends suffice to say that a decline in the working age population as big as

FIGURE 3 Japanese asset prices from relevant peaks

FIGURE 4 Japanese working age population and core CPI

Source: Barclays Research, Haver Analytics Source: Haver Analytics, Barclays Research

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the one experienced in Japan will almost certainly have had some impact on Japans inflation trends (Figure 4). An anomaly of Japans labour market is a wage structure that tends to peak in the 50-59 age bracket, before falling markedly (Figure 5). Alongside the magnitude of the demographic shock, this would suggest that the effect of demographics has been unusually large in Japan a theme we will explore below.

Inadequate policy response. Criticisms of Japanese policymakers response to the deflationary period are neither new, nor especially controversial these days. However, it should be noted that Japans deflation experience occurred when there was no modern precedent and that any policy made then had to balance lingering concerns about Japans late-1980s asset price bubble. As such, our ex-post analysis of Japans policy response is not meant to be a criticism of those choices, especially given the ex-ante situation Japanese policymakers were facing. History may be harsher on eurozone (and US) policymakers if similar policy mistakes are made given that Japan does now provide a clear antecedent.

The main literature on Japans deflationary era focuses on two policy mistakes. The first was that monetary policy was left too tight relative to underlying economic conditions. Figure 6 looks at the evolution of a simple Taylor rule for Bank of Japan (BoJ) policy since 1989. The first cut in the BoJs call rate happened in the middle of 1991 or 18 months after the top of the equity bubble (the TOPIX had fallen 30% by then). From there, rates were cut aggressively, although it was 1999 before rates were officially cut to zero. The BoJ did eventually launch QE in March 2001, though the actual balance sheet expansion was both slower and more modest than the balance sheet expansions by major central banks after the collapse of Lehman Brothers (this has clearly changed with the launch of Abenomics). Overall, the Taylor rule analysis suggests Japans monetary policy was persistently too tight for underlying economic conditions from the middle of 1998 until just recently. Ironically, Japanese monetary policy today appears slightly too loose as the unemployment rate has fallen and inflation has risen markedly over the past year though it is likely to remain that way for some time as the Abe government and Bank of Japan attempt to pull Japan out of long-term deflation.

Academic literature has also argued that Japanese policymakers were slow in cleaning up the significant losses in Japans banking system caused by the collapse in asset prices. To start, banks did not disclose any non-performing loan (NPL) ratios before 1993 and started to disclose the ratio on a consistent basis only in 1998. Over the course of the crisis, non-performing loans at Japanese banks reached a peak of 9% (Figure 7). But it was only in the autumn of 2002 some five years after deflation began that Heizo Takenaka was appointed head of the Financial Services Agency and put a significant emphasis on recapitalization. From that point, non-performing loans in Japans banking system fell markedly and have in recent years returned to pre-crisis levels. One important

FIGURE 5 Per capita manufacturing wages in 2006: Japans unique structure

FIGURE 6 Taylor rule for Japan monetary policy stance

Source: Japan Ministry of Health, Labour and Welfare, Barclays Research Source: BoJ, IMF, Barclays Research

Japans monetary policy was persistently too tight for underlying economic conditions from mid-1998 until just recently

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consideration, however, is that even with Japanese banks returning to better health in recent years, loan growth has been very weak and the proportion of loans to government bond holdings has remained far below pre-crisis levels. (On the latter, large accumulation of government bonds on bank balance sheets at the expense of making loans is a natural reaction in a deflationary environment a trend that Abenomics would like to curb).

Eventual de-anchoring of inflation expectations. There is no easy way to measure inflation expectations in Japan dating back to the start of the deflationary period. Inflation breakeven data and price expectations from the household survey began only in the early 2000s. That said, research by the Bank of Japan3, has used the evolution of consensus expectations to highlight the shift in inflation expectations that occurred in the late 1990s (see chart on page 12 of the BoJ paper). Originally, the drop in inflation was expected to be temporary: in 1996, consensus forecasts for year-ahead Japanese inflation began to fall, but forecasts for 6-10 years out were broadly unchanged (in the range of 1-2%). By 1998, 1-year-ahead forecasts for inflation had fallen below zero, but it was not until 2003 that zero inflation was expected on a longer-run horizon some five years after Japan entered deflation. A key lesson for the ECB from the Japan experience is that focusing on long-term inflation expectations measures (the ECB often cites 5y5y breakevens as its preferred benchmark) is reasonable, but short-dated inflation expectations dynamics can provide important information on how long-term expectations are evolving.

Surge in Chinese exports. Academics are divided on the impact of Chinas export surge on global inflation trends. We will simply say that it is hard to imagine that Chinas export surge did not have direct or indirect effects on Japanese price levels. The strong entrance of Chinese exporters to the global trade market placed a significant downward pressure on tradable goods prices, and intensified competition worldwide. One possible illustration of this is the relative performance of export market shares in China and Japan in the past decade (Figure 8); China gained a significant market share, while Japan, despite adjusting export prices considerably, has continuously lost global export share (Figure 8).

Comparing the eurozone with Japan We now make direct comparisons, where relevant, with current conditions in the eurozone. There is no consensus on what start date to use in a comparison of Japan and the eurozone. For simplicity, we have chosen December 1989 in Japan and July 2007 in the eurozone points where asset prices peaked and significant subsequent declines in these prices led directly or indirectly to negative shocks for the macro economy and bank balance sheets. The following is a summary of how these variables compare.

FIGURE 7 The evolution of Japanese banks NPL ratio

FIGURE 8 Japan has faced strong competition from Chinese exports

Source: Haver Analytics, Barclays Research Note: Export market shares are measured by export volume relative to total

foreign demand for the countrys exports, ie its export market. Source: Haver Analytics, Barclays Research

3 Chronic Deflation in Japan, Kenji Nishizaki, Toshitaka Sekine, Yoichi Ueno, Bank of Japan Working Paper Series

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The size of the financial shocks It is often assumed that Japans asset price declines were far larger than those experienced in the eurozone. Although this is true over the full course of Japans deflation experience, asset price declines in the eurozone today do not differ drastically from those in Japan at a similar stage of the crisis. Figures 9 and 10 show the size of the asset price declines in Japan since 1989 and in the eurozone (aggregate and periphery) since 2007. A few points are clear. First, in the initial stage of the crisis, the decline in eurozone equities was actually bigger than in Japan aggregate eurozone and peripheral equities fell by more than 60% from the 2007 peak in the first 18 months. Since then, aggregate eurozone equities have recovered though the aggregate drop (30%) is not much smaller than Japans (39%). Indeed, peripheral equities are still below Japanese equity levels six years into the crisis.

It is much harder to compare the effects of land/housing declines, but it is probably fair to say that the overall impact on housing price declines in the eurozone has been far smaller than Japans experience. Indeed, for the eurozone as a whole, residential property prices are largely where they were in 2007 thanks in part to a mini-boom in German house prices. Still, for this analysis, it is also worth highlighting that those eurozone countries that experienced housing bubbles and busts, such as Spain and Ireland, have seen price declines much larger than those experienced in Japan at a similar point in the cycle (Japans land prices did eventually far surpass the current experience in Spain and Ireland).

We draw three lessons from the asset boom/bust comparisons. First, if asset price deflation was truly a driver of broader Japanese deflation, we should probably view the experience in the eurozone as only slightly less worrying than Japans experience. This is especially true if, as we will explore, the question of eurozone deflation risks becomes more region-specific: for example, deflation in Spain under this framework is cause for concern. Second, one important difference that may argue that eurozone asset price deflation is a smaller risk is the absence of equity cross-share holdings in European banks. Indeed, Japans financial institutions held around 40% of the equity market when the bubble burst, which exacerbated the hit to bank balance sheets. This is not an issue for eurozone banks today. Third, although the interaction between economy-wide and asset-price deflation is complex, we should remember that a major leg of Japans asset price deflation happened once economy-wide deflation had become entrenched. Indeed, if we were to extend Figures 9 and 10 into Japans actual deflationary period, Japanese equities bottomed only in 2003, at barely 20% of December 1989 levels (which means they fell another 50% from what had already been considered cheap levels in the mid-1990s). Meanwhile, Japanese land prices remain some 65% below

Eurozone asset price declines are more modest, but probably closer to Japans experience than many believe

FIGURE 9 Equity market performance from peak of market

FIGURE 10 Land/house price performance from peak of market

Source: Bloomberg, Barclays Research Source: Bloomberg, Haver, Barclays Research

The Japanese experience warns that European asset markets could get much cheaper if the eurozone slips into deflation

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their 1991 peaks. In other words, while the common view is that European asset markets are cheap at current levels, the Japanese experience warns that they could get much cheaper if the eurozone slips into deflation.

Negative demographics Eurozone demography is turning negative, but the trend will be shallower than Japans4. The working age population in the euro area reached its peak in 2011, closely tracking the peak of the credit crunch, similar to how things played out in Japan. However, despite these similarities, the demographics of the euro area are different from Japans in several ways. First, although Japan experienced a freefall in the working age population, the post-peak downturn in all the major euro area countries except for Germany is projected to be considerably more muted (Figure 11). In fact, the stark difference between the fast deterioration of Japans WAP and the more moderate one in the euro area countries will only increase over time (Figure 12), according to UN projections.

Within the euro area, demographic trends vary greatly in size, speed, phase of transition and overall severity. Figure 13 provides a coherent framework using WAP and dependence ratios to assess the demographic risk of each of the nine most populated euro area countries relative to Japan. The last column ranks each of the EA-9, using Japans metrics as benchmark. As the table shows, Portugal is in the best demographic position, thanks to a very slow expected rise in its dependence ratio in the coming decade and a slower decline in its WAP. French demographics are also relatively positive because of an odd mix of better WAP dynamics offset by a significant rise in the dependence ratio. Perhaps surprisingly, Italys demographics are in the middle of the pack its WAP fall is expected to be nearly as negative as it was in Japan, but the dependency ratio rise will likely be more muted. Germany has had the weakest demographics in the eurozone in recent years and will continue to face the biggest challenges for some time the result of a rapid expected deterioration in the dependence ratio and more severe WAP shrinkage. That said, Germanys experience with very challenging demographics, and the contrast in its economic performance relative to Japan, should underscore that the impact of demography trends on price levels is not very clear cut, a point we explore in more detail in Chapter 3.

4 This section is an excerpt from our recent Focus on January 27.

Eurozone demography is turning negative, but the trend will be shallower than Japans

FIGURE 11 Trends in working age populations from relative peaks

FIGURE 12 Working age population trend after peak relative to Japans post-peak experience

Source: UN population statistics, Barclays Research Source: UN population statistics, Barclays Research

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FIGURE 13 Euro area countries demographic risk scorecard*

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2.62 -1.43 -3.23 1.28 50.5 2.1 3.3 -10.3 6.8 5.3 France 1 0.43 2077

0.61 -0.15 -5.25 2.56 56.6 2.9 7.2 -9.6 3 4.8

Spain 1.5 0.84 2011

12.63 -0.9 6.78 1.81 49.4 3.6 5 -8.8 5.1 4.7 Austria 2.1 0.32 2017

1.9 -2.62 -3.96 0.09 49 1.3 6.1 -11.1 4 3.8

Italy 1.3 0.24 2010

3.43 -2.18 -2.43 0.53 54.3 4.5 5.6 -8 4.5 3.7 Greece -0.9 -0.17 2001

8.36 -1.41 2.5 1.3 52.3 4 5.7 -8.5 4.4 3

Belgium 1.2 0.6 2011

7.32 -1.71 1.46 1 53.9 1.5 7.7 -11 2.4 2.9 Nether. 2.6 0.13 2009

3.94 -2.14 -1.92 0.57 51.8 4 7.8 -8.5 2.3 2.6

Germany 1.6 -0.35 1998

2.92 -3.24 -2.94 -0.53 52.3 3.6 7.3 -8.9 2.9 1.3 Japan 0.4 -0.77 1995

5.86 -2.71 0 0 61.5 12.5 10.1 0 0 1

Note: *The calculation uses the dependency ratio of country X relative to Japans as a starting point. Then it adds the weighted contributions of the difference relative to Japan in the post peak-decade growth in working age population and the change in the dependency ratio over the next decade. A final adjustment is made to account for the difference in peak years in working age populations: +/-1 point for 10 years or more difference from the peak year of the euro area (2011). Source: Barclays Research

Monetary policy Increasingly, monetary policy in the euro area looks too tight, just as it did in Japan toward the end of the 1990s.5 As noted in the previous section, a simple Taylor rule analysis would suggest that Japans monetary policy was too tight for nearly 15 years, given the underlying conditions in the economy (Figure 14). Using the same comparison for the euro area, the Taylor rule suggests that monetary policy has been broadly appropriate through much of the crisis period, but is beginning to slip toward being too tight, as was the case at a similar point in the crisis in Japan (Figures 15). Indeed, since early 2013, as a result of renewed economic weakness and a gradual decline in inflation, Taylor rates have fallen back into negative territory. The two refi rate cuts and the introduction of forward guidance have put a lid on money market rates, but the gap between the Euro OverNight Index Average (EONIA) and the Taylor rate has widened consistently, suggesting that monetary policy is now too tight. In addition, the ECBs balance sheet has contracted since mid-2013 as a result of the Long-Term Refinancing Operation (LTRO) repayment. Of course, this passive tightening can be seen as a partial (and ongoing) normalization of financial markets, as international investors return to the European periphery and banks gradually regain market access. Nevertheless, it could result in renewed weakness in money growth that would be particularly damaging amid already very low inflation.

FIGURE 14 Japan monetary policy stance using simple Taylor rule

FIGURE 15 Eurozone monetary policy stance using simple Taylor rule

Source: BoJ, IMF, Barclays Research Source: ECB, European Commission, Barclays Research

5 See A simple Taylor rule suggests the ECB should ease policy more aggressively to avoid a 'Japanese scenario' in the Global Macro Daily (21 January 2014).

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13 February 2014 12

Although there are significant differences between Japanese monetary policy at the onset of deflation at the end of the 1990s (absence of a medium-term inflation target for the BoJ, Asian crisis, and entry into recession) and the current situation in the euro area (macroeconomic adjustment in peripheral countries), a simple analysis of past monetary policy with the Taylor rule suggests that the ECB risks being late to counteract deflationary forces, just as the Bank of Japan was during its lost decade. This supports the view that monetary policy should be eased more aggressively, especially given that the current contraction in the ECBs balance sheet is acting as a passive tightening of monetary policy.

The banking sector Eurozone banks were slow to recapitalize but have recently stepped up their efforts; the asset-quality review (AQR) should help stem any further concerns.6 As mentioned, the absence of large equity-cross-share holdings in European banks suggests the balance sheet holes created by the asset bubble decline were likely smaller than among Japanese banks. Comparable NPL data, while an imperfect measure, support this view (Figure 16). In terms of policy, in contrast to the Japanese experience, while the response to banking sector problems at the aggregate European level has been slow, recapitalisations at the country level, particularly in countries where property bubbles burst and problems were particularly acute, were relatively fast. For example, Ireland first injected capital in the form of preference shares in 2009. Furthermore, independent stress tests done at country level in Ireland and Spain were aimed at balance sheet clean-up and recapitalisation. In aggregate, around 290bn of taxpayer-funded capital was injected into European banks between 2008 and 2011. Another 50bn was injected into Spanish banks in 2012. Banks also raised capital privately and 10-15% of the EU banking system is currently under the State Aid framework and undergoing forced restructuring.

Meanwhile, the ECB strongly believes its upcoming comprehensive assessment will force eurozone banks to fill in any further balance sheet gaps in the coming months. The assessment involves the AQR, a stress test and a review of funding/liquidity positions and is being conducted ahead of the ECB taking over as the single supervisor in November 2014. The AQR applies a common definition of non-performing loans, a common methodology on the classification of restructured loans and looks at provisioning levels. This should draw a line under the balance sheet clean-up process and show that the capital raise since the beginning of the crisis is sufficient or that more must be done. Admittedly, some countries such as Portugal and Italy may be candidates for further recapitalization, but this is already well known and unlikely to be a source of systemic stress for eurozone banks. Overall, it would suffice to say that the eurozone bank balance sheet repair is well ahead of similar efforts in Japan in the early 2000s. Still, the drop in eurozone lending growth was steeper and happened quicker than in Japan (Figure 17).

6 See The ECB asset quality review, Jonathan Glionna, 11 October 2013 and The ECB comprehensive assessment Germany, Jonathan Glionna, 10 December 2013

Eurozone banks were slow to recapitalize but have recently stepped up their efforts

If the ECBs optimistic view proves correct, eurozone bank balance sheet clean-ups will occur 4-5 years sooner than they were done in Japan

FIGURE 16 Non-performing loans look to be a smaller problem in the eurozone than in Japan

FIGURE 17 Loan growth decline has been much faster and deeper in the eurozone than in Japan

Source: Datastream, Barclays Research Source: Datastream, Barclays Research

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13 February 2014 13

Inflation expectations Long-term inflation expectations are well anchored in the eurozone, but short-dated expectations are shifting lower and zero rates could complicate the situation. Unlike Japan in the 1990s, the ECB has various inflation expectations measures at its disposal. A list of the measures typically used was included in a 2011 publication.7 In recent months, the ECB has maintained that inflation expectations remain firmly anchored, and has openly contrasted this dynamic with Japans experience. We broadly agree, but there are parallels with Japans experience in the late 1990s that bear watching. The ECB typically cites 5y5y breakeven swaps in maintaining its view that long-run inflation expectations remain well anchored. Although it is hard to argue against this view, short-dated inflation expectations are beginning to shift down, if only modestly. Using the EUR HCPIx options market, the cumulative probability that the market is pricing below zero inflation over the coming year is nearly 20%, compared with just under 10% six months ago (Figure 18). By contrast, 10y inflation expectations have not moved over the same period (Figure 19). Although we do not have similar breakeven data for Japan, the de-anchoring of inflation expectations in the late 1990s followed a similar pattern.

Another important consideration in comparing the effects of inflation expectations is the impact of zero rates especially since the eurozone has only recently reached this point. Recent economic research 8 has examined this problem extensively and concluded that traditional monetary policy rules plus the zero-lower bound on interest rates can create a stable long-run equilibrium that involves both deflation and extraordinarily low policy rates, referred to as the unintended equilibrium. The Japanese experience suggests the unintended equilibrium can be stable and difficult to reverse. Figure 20 shows Europe has gradually drifted toward the unintended equilibrium9. The light blue dots in the figure represent the combination of inflation and policy rates in Europe since 2009, compared to the dark blue dots representing pre-crisis values. The ECB has recently lowered policy rates to 25bp, the effective zero-lower bound, but has yet to fully reverse disinflationary trends. If inflation and inflation expectations in Europe begin to drift even lower, then the ECB may be forced into further unconventional monetary policy or risk a Japanese-style outcome.

FIGURE 18 Probability distribution for eurozone inflation outcomes over next year: Inflation expectations are shifting lower

FIGURE 19 Probability distribution for eurozone inflation outcomes over next 10 years: Longer-run inflation expectations more stable

Note: Charts show probability distribution of annualised inflation over the relevant tenor, as implied by zero-coupon inflation options and inflation swaps (Note: the starting point of the period over which the probability is calculated is determined with a 3-month lag, as per the convention in the inflation swaps market). Source: Barclays Research

Source: Barclays Research

7 See Inflation expectations in the Euro Area: A Review of Recent Developments, ECB Monthly Bulletin, February 2011. 8 See Jess Benhabib, Stephanie Schmitt-Grohe, and Martin Uribe, 2001, The Perils of Taylor Rules, Journal of Economic Theory, 96, 40-69. Also see James Bullard, Seven Faces of The Peril, Federal Reserve Bank of St. Louis Review, September-October, 2010. 9 Global Macro Daily, 7 February 2014

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Long-term inflation expectations are well anchored in the eurozone, but short-dated expectations are shifting lower and zero rates could complicate the situation


13 February 2014 14

China and Asia disinflation pressures It would seem to hold that the effects of Chinas export surge should be smaller for the eurozone than they were for Japan, but it is worth noting that the eurozone is facing both domestic and global deflationary pressures. At the global level, core goods disinflation has been in place since late 201110. A number of reasons have been cited for this, including Chinas overcapacity, the yens plunge and the decline in commodity prices. We assume it is probably all three and perhaps a few others. We also assume that no clear reason emerges for this global disinflation trend to reverse in the coming months, and that the disinflation pressures in global core goods prices has probably had some impact on eurozone price levels (Figure 21).

What makes the eurozone different? This next section focuses on three important differences between Japan and the eurozone, each of which probably increases the potential for a prolonged period of deflation, at least in certain parts of the eurozone, if not necessarily in the region as a whole.

The eurozone needs to be viewed as a collection of economies and markets To start, although the importance of monetary policy in establishing deflation risks makes comparisons between Japan and the eurozone reasonable, any prognosis of deflation risks for the eurozone must recognize the heterogeneous aspects of the eurozone economy and financial market. This is especially true given that at the heart of the eurozone crisis is a collection of internal imbalances that were allowed to build up for nearly a decade prior to financial shock. Reversing these imbalances will naturally place some economies at much higher risk of deflation than others. One simple illustration of this is to return to our analysis of the eurozones monetary policy stance, but focus on how ECB policy is felt across different eurozone countries. Figure 22 shows the relative monetary stance for Germany, Spain and the overall eurozone using a Taylor rule framework. Prior to the crisis, the eurozones single monetary policy framework, while broadly correct for the region, was far too loose for Spain, yet too tight for Germany. Since then, the relative policy stance has shifted sharply. Today, the appropriate policy rate for Spains economy is near -4%. For Germany, the right policy rate is closer to +2%. In the event, the current policy rate of near zero is too tight for the region as a whole, but only modestly so. Still, current policy will only exacerbate deflationary pressures in Spain and other periphery countries, and if left unchecked could start to raise deflation risks for the region as whole.

10 See Keeping a lid on inflation in Global Macro Daily, 10 January 2014

FIGURE 20 Short-term policy rates and inflation in the eurozone

FIGURE 21 Global core goods prices disinflation has affected eurozone

Source: ECB, Eurostat, Haver Analytics, Barclays Research

Source: Haver Analytics, Barclays Research

Regional factors are important in assessing deflation risks, especially given the absence of a single financial market

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13 February 2014 15

FIGURE 22 Relative monetary policy stance within the eurozone

FIGURE 23 German equities have outperformed vs other EA markets

Source: AMECO, Haver Analytics, Barclays Research Source: Bloomberg, Barclays Research

Of course, none of this would matter much for asset allocation purposes if the eurozone were a single financial market, but it is not. While many equity investors view the eurozone as a single market these days, the country-by-country variability has been huge in recent years. Essentially, Germanys equity market has significantly outperformed peripheral and most other equities, an outcome one can easily understand given Germanys better growth and, as we have shown, more favourable monetary policy backdrop (Figure 23). Similarly, while talk of a single government bond market has increased since the start of the crisis, any euro bond solution is likely years away (if it ever happens) and is likely to have little impact on the legacy of outstanding debt in peripheral countries. In other words, for asset allocation purposes, understanding single-country deflation risks is just as important in assessing the risks for the region as a whole.

The eurozone has embarked on a markedly different fiscal path than Japan Another big difference between Japan and the eurozone is the path of fiscal policy. In Japan, aggressively expansive fiscal policy was at the core of the crisis response, pretty much from the beginning. Indeed, since 1993, Japans cyclically adjusted fiscal deficit has averaged nearly 6% of GDP annually, and remains near 10% today. The Abe government is now aiming to half the primary deficit by FY14-15 and achieve a primary surplus five years later (though there are significant doubts about whether this can be achieved).

The eurozones fiscal policy response has been very different. After a prolonged period of loose fiscal policy in the pre-crisis years (especially, but not limited to peripheral countries), followed by a major round of fiscal spending in response to the crisis, the eurozone has embarked on a policy of fiscal tightening in recent years. We estimate that the euro area on average has cut its structural budget deficit by a sizable 3.2 % of GDP over 2011-13, including significant cuts in several peripheral countries, such as Spain (4% of GDP) and Greece (nearly 10% of GDP). There has been a long debate on the fiscal multipliers, with a range of estimate between 0.5 and 2.0. Our best rough estimate is somewhere around 1.2-1.3. This means that the impact of the fiscal adjustment over 2011-13 has probably been between 3.5% and 4% of GDP. Figure 24 illustrates just how different the fiscal policy responses of Japan and eurozone have been judged at similar starting points for the crisis.

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13 February 2014 16

FIGURE 24 General government cyclically adjusted fiscal balance

Source: Haver Analytics, Barclays Research, OECD

The good news for the eurozone is that fiscal consolidation will be much slower from 2014 onward. We see a negative impulse from fiscal policy of 0.3% of GDP in 2014, 0.2% of GDP in 2015 and 2016 and 0.1% in 2017. The structural deficit would be more or less eliminated by the end of the decade. That said, when thinking about current deflation risks, we need to consider the effects that the fiscal austerity to date has had on economic conditions. One way of thinking about this is to return to the comparative output gaps between Japan and the eurozone at a similar point of the crisis (Figure 2). We have argued the aggregate asset price and banking shocks have not been quite as large in the eurozone as they were in Japan, but the impact of tight fiscal policy on many eurozone countries has helped push the output gap deeper, and at a much earlier point than was the case in Japan. Once the drastically different fiscal policy response in the eurozone is taken into account, we would argue that the risks of a period of deflation, certainly for many peripheral countries and perhaps for the region as a whole, are not that different to the risks Japan was facing in the mid-1990s.

Some deflation is actually part of the solution to the eurozone crisis A final distinction between the eurozone and Japan, and perhaps the most important one is that in the eurozone, some temporary deflation within the region is an unfortunate, but natural by-product of solving the eurozones crisis. In other words, in the absence of exchange rate devaluations (a route the euro makes impossible for peripheral countries), internal devaluation is needed by many eurozone countries to regain competitiveness.11

Credit-fuelled growth in several member states in the previous cycle meant that the fundamental features of member states economies were overlooked (eg, efficiency of the labour market, product markets, public services). Lack of efficiency implied that labour costs grew much faster than productivity, in turn implying a significant deterioration in unit labour costs (ULC). Peripheral countries were particularly affected between the start of EMU and the beginning of the financial crisis in 2007.

Crisis-hit countries have reacted with a raft of reforms, including wage and price moderation and, where possible, a shift from labour taxes to consumption taxes. This so-called internal devaluation aims to depreciate the real effective exchange rate by realigning labour costs with productivity, thereby restoring competitiveness and, as a result, unwinding current account deficits, a first step toward a sustainable growth path for these economies.

11 Internal devaluation increases deflation risks Global Macro Daily, 30 January 2014

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13 February 2014 17

This adjustment has occurred in various forms and at various speeds. In some countries, ULC correction has occurred mainly via productivity gains through labour shedding, at least in a first step (eg, Ireland, Spain, Portugal). Elsewhere, or as a second step, it has resulted from a fall in labour costs, ie, compensation per employee (Ireland, Greece and, more recently, Spain). An increase in productivity coupled with a fall in wages has pushed ULCs sharply lower. Amid falling producer prices and shrinking domestic demand, inflation has declined, and even turned negative in Ireland, Greece and Cyprus.

Countries in which the internal devaluation has been more successful are generally those where structural reforms have also been readily implemented. The intensity of reforms has been strongest in Ireland, Portugal, Spain, and, to some extent, Greece. By contrast, France and Italy have fallen behind in the reform race.

It is important to bear in mind that internal devaluation and, more significantly, structural reforms, imply a de facto alteration of (if not a break with) previous price-setting relationships. For example, as far as the Phillips curve (relationship between nominal wage growth and unemployment rate) is concerned, there is no way to know whether labour market reforms imply a different equilibrium point on the same curve or whether the curve has actually changed shape. Even if the reform agenda in all these countries were only partially implemented, the price adjustment would likely continue for several more years. The picture is particularly negative for France and Italy. Assuming that unit labour cost differentials with Germany return to their 2004 levels, it would imply a relatively aggressive ULC adjustment to take place over the next four years for these two countries (Figure 25).

Net-net, continuing competitiveness adjustments are playing an important role in explaining euro area inflation weakness. This is a fundamental difference with the Japanese situation in the 1990s. Indeed, it is important to understand and monitor the eurozone-specific variables at play, and their effect on consumer prices, in order to assess the deflation threat in the region, and within each eurozone country. Put another way, the weakest countries in the EA are undertaking structural reforms and an internal devaluation process that, if successful, may enhance total factor productivity (TFP), growth potential and eventually prices. As in the weaker EA countries, a key factor behind Japans great stagnation was a story of declining TFP and failure to address its roots Abes third arrow (structural reform) is about precisely that. On this account, as well as on the comparatively quicker clean-up of zombie banks in the periphery, Europe appears to have reacted faster and more forcefully than Japan, but at the expense of higher near-term deflation risks.

FIGURE 25 Marked ULC adjustment lies ahead for France and Italy

Source: Haver Analytics, Barclays Research

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Continuing competitiveness adjustments help explain euro area inflation weakness


13 February 2014 18

Dont underestimate the risk of eurozone deflation In this section, we assess the risks of a prolonged bout of eurozone deflation along with likely trends and key focus points within the region. Overall, our assessment is that the risks of a region-wide deflationary period are significant, and certainly bigger than what is currently priced into financial markets or being publically acknowledged by eurozone policymakers. Either way, the likelihood of a prolonged period of falling price levels in at least several eurozone countries looks very likely.

Figure 26 summarises our analysis of the similarities and differences when comparing Japans deflation era to the eurozone situation today. Below are the key takeaways:

The early-stage drivers of Japans deflationary shock are nearly all present in the eurozone today, although in most cases the impact is likely to be less severe, at least in any region-wide assessment of eurozone deflation risks.

Asset price deflation in the eurozone has been more modest in the aggregate, although house/land price falls in some peripheral countries are comparable to Japans episode.

Negative demography is unlikely to be as acute as the trend in Japan.

Bank capital impairment has been addressed more quickly in the eurozone, and 2014 is expected to put a lid on further bank balance sheet concerns.

The real effective euro exchange rate has not been as big a driver of the deflation trend, but it is an increasing drag on prices.

Against this, important differences in the eurozone today likely suggest the deflation risks do not differ meaningfully from Japan in the mid-1990s.

Tight fiscal policy has pushed the eurozone output gap to levels more negative than they were in Japan at a similar stage of the crisis.

Uneven monetary policy (too tight in periphery, too loose in Germany), along with ongoing internal devaluations have pushed several countries into deflation already. (It should be noted that although internal devaluation in the periphery and semi core on the back of structural reforms will contribute to near-term deflation risks, if successful it should have longer-run positive implications for growth and inflation.)

Global disinflation pressures remain relatively large, thanks at least in part to weak commodity prices, Chinas overcapacity and a weak yen.

FIGURE 26 Japan vs the eurozone: A summary of the important similarities and differences

Deflation factor Likely Impact on price levels Japan's experience Eurozone today

Financial/asset price shock

large negative large early driver medium early driver

Demographics unclear, but likely small negative

probably medium, early shock to price levels

impact should build from here, but still unclear and likely small

Monetary policy stance

large/medium negative large impact, especially after Japan entered deflation

turning tight for eurozone, entering a critical stage in 2014

Bank capital impairment

large/medium negative large early driver An important early driver, but bank recaps have picked up; 2014 critical

Inflation expectations medium negative medium impact once Japan entered deflation (hard to track)

short-end expectations falling; entering a critical stage

Real exchange rate appreciation

medium negative probably medium, early shock to price levels

real effective euro unchanged over period

Global disinflation pressures

medium negative low/medium in 2000s a medium driver of disinflation in past two years

Fiscal policy medium negative expansionary/inflationary probably medium/large deflationary shock

Intra-regional monetary policy

large/medium negative n/a large negative shock for peripheral countries

Internal devaluation measures

large/medium negative n/a Large negative shock for peripheral countries

Source: Barclays Research


13 February 2014 19

In considering the country-by-country risks, we use a synthetic indicator replicating the IMF methodology12. The assessment is made on answers to a series of closed-ended questions equally weighted by country/region scores: 1 if a given series breaches a pre-defined threshold, and 0 if not. The higher the score, the higher the deflation risk (for more details, see Sensing the deflation risk, Euro area focus, 17 May, 2013).

Figure 27 looks at the evolution of this deflation risk indicator for the eurozone as a whole and a few important countries, while Figure 28 shows the details by country. We summarize the important messages below:

The eurozone-wide deflation risk indicator has crossed into the high territory for the first time since Q4 2009, although it is still at the lower end of this range.

Unsurprisingly, the peripheral country deflation risk scores are very high and more recent data suggest deflation risks have picked up again (after easing a little).

Understandably, deflation risks in Germany and most other northern eurozone countries remain comparatively low, although perhaps not low enough given the need to offset deflationary pressures in the periphery related to ongoing internal devaluations

France and Italy are both still in the modest risk zone, but more recent data suggest deflation risks are building; given how far behind these countries are in restoring competitiveness, deflation risks are clearly to the upside

FIGURE 27 Deflation vulnerability index for selected euro area aggregates

Source: Haver Analytics, IMF, Bloomberg, Barclays Research. Note: in brackets, the weight of the grouping in the euro area HICP basket. Greece is missing before 2011

12 Deflation: Determinants, Risks, and Policy Options Findings of an Interdepartmental Task Force, IMF, April 2003

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FIGURE 28 Deflation risk indictor for eurozone and individual countries

Latest

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Is GDP growth in the last 3y < 2/3 previous 10y? 1 0 0 1 1 1 1 1 1 1 1 1 1 1 0 0

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Total (arithmetic average) 0.55 0.20 0.30 0.40 0.50 0.40 0.30 0.80 0.60 0.30 0.50 0.50 0.30 0.80 0.50 0.30

Headline HICP inflation rate 0.7* 1.2* 0.8 0.6* 0.3* 1.4 1.2 -1.8 0.2 1.9 0.4 0.4 1.5 -1.3 2.0 1.0 Note: * refers to flash January data. Data otherwise refer to December prints. Source: Barclays Research; IMF

2014 a critical year for the eurozone deflation verdict Overall, the eurozone is entering a critical stage in determining whether it will avoid a bout of region-wide deflation (existing deflation trends in individual member states look set to persist). Regional considerations aside, today is much like Japans crucial 1996-97 period. Then, the combination of significant shocks, negative demographics, undercapitalized banks and an expensive exchange rate left Japan on the cusp of deflation. While these deflationary forces are not as large in the eurozone today, the added deflationary pressures from tight fiscal policy, tight monetary policy (region-wide, and certainly in some countries), internal devaluations and global disinflationary pressures means the eurozones risks are not meaningfully different than they were in Japan in 1996-1997.

In the end, Japan did fall into deflation in the late 1990s and remained there for more than 15 years. That said, it appears that a series of policy mistakes, a related de-anchoring of inflation expectations and some bad luck is what finally sealed Japans deflation case. The eurozone looks in many ways quite similar to Japan in the mid- 1990s. According to our Taylor rule estimate, monetary policy is, for the first time, too tight, if only modestly so. Shorter-dated inflation expectations are shifting lower, while longer-dated expectations remain anchored (a pattern observed in Japan). And bank lending remains depressed, despite some reason for optimism around eurozone bank recapitalization efforts.

If there is one important lesson for eurozone policymakers from Japans experience, it is that the next year or two will likely be critical in curbing deflationary pressures. As Japan has shown, one element in avoiding deflation will likely be luck. Given the eurozones large negative output gap, the region can ill afford any further financial or economic shocks. That said, aggressive policies to avoid deflation may also be needed. Reassuringly, the bank balance sheet clean-up is well under way. The ECBs early reaction of recent disinflationary pressures is also a cause for optimism, if only modestly so. Looking ahead, more monetary policy easing may be needed, and with interest rates already virtually at zero, the options left for the ECB are not especially attractive ones from the banks point of view (ie, negative deposit rates, some form of QE, etc.)

As noted, our assessment on eurozone deflation is that the risks are high, but not yet high enough to call it our central scenario. During this critical next year or two, the path of ECB policy will be key, as will the behaviour of banks as balance sheets are repaired. As important will be developments at the country level. We expect internal devaluations underway in many peripheral countries to remain a deflationary force for some time.

Recent ECB policy response is reassuring, but more may be needed to curb deflation risks, especially in case of additional financial or economic shocks


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Assuming competitiveness vis--vis Germany is restored to 2004 levels, we would expect internal devaluation pressures to be in place over the next few years, particularly stemming from a needed adjustment in France and Italy.

Ultimately, developments in Germany, France and Italy may well hold the key as to whether region-wide deflation is avoided. While Germanys deflationary pressures are very modest, the truth is that German inflation levels are running too low to offset the major deflation pressures in the periphery simple math would argue Germany needs an inflation rate above the eurozones 2% target to offset deflation pressures elsewhere (current Germany CPI is 1.2% y/y). France and Italy deflation risks are higher than Germanys. Given neither have really begun to restore competitiveness, we would expect deflation risks to only rise in the coming few years. How and when this process unfolds will be a crucial determinant of deflationary risks for the eurozone.

The impact of deflation on asset allocation choices We build on Japans experience to consider the potential consequences for eurozone markets and asset allocation were deflation to become reality. We focus on five areas. First, we consider how asset allocation between equity and fixed income could change in a deflationary environment. Second, we analyse the potential effects on bank behaviours and valuations. Third, we look at the potential impact of deflation on the euro. Fourth, we simulate what deflation might mean for eurozone debt sustainability, all else equal. Finally, we consider the linkages between deflation/low rates and corporate behaviour.

Deflation has had a marked effect on Japanese asset allocation As we have written before13, inflation can significantly alter the optimal asset allocations for a portfolio of equities and fixed income in a given currency. Chapter 6 (Shifting inflation landscapes: Implications for Japan and Europe) takes a more detailed look at the effects of inflation levels on asset allocation. In considering the risks of a prolonged bout of deflation in the eurozone, we make the following points.

First, it should come as no surprise that an optimal asset allocation strategy markedly changes depending on the inflation regimes. Figures 29 and 30 look at Sharpe ratios for equity and fixed income returns in the US since 1970. For equity markets, the risk-adjusted returns are fairly symmetrical (and bell shaped). At the two extremes low inflation/deflation and high inflation equities perform poorly. This suggests that there is an inflation sweet spot for equity nestled somewhere between super-low and super- high inflation outcomes. By contrast, the picture for fixed income returns across inflation regimes is far more linear the lower the inflation (even deflation) the better

13 The Japan macro trade: Watch Japanese investors in 2014, Global Macro Daily, 11 December 2013

FIGURE 29 Average US equity performance across inflation deciles

FIGURE 30 Average Treasury performance across inflation deciles

Source: Bloomberg, Barclays Research

Source: Bloomberg, Barclays Research

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the returns for fixed income, and vice versa. As Japan exits deflation for the first time in nearly 20 years, and the eurozone flirts with entering deflation, the implications could be significant. In the case of the eurozone, a bout of deflation (or even a prolonged period of very low inflation) would argue strongly for an asset allocation overweighting fixed income and underweighting equities.

A look at the Japan deflation experience illustrates how large asset allocation differences can be depending on the level of inflation. Figure 31 looks at annualized Sharpe ratios during Japans deflationary era for various government bonds, slope trades and equities. We also show Sharpe ratios during periods of above and below median lagged inflation. As one would expect, Japans deflationary period strongly favoured a large overweight in fixed income and an underweight in equities. Fixed income returns were largely the same in either low inflation or deflationary periods, but equity returns were clearly different depending on the deflation outcome (down in below-median periods for inflation, up otherwise). Interestingly, it would also seem that deflation, or, more likely, zero interest rates, had a discernible impact on curve trade returns. Most notably, short-end fixed income bull flatteners were far more successful in Japan than other countries during the period studied.

As to whether these scenarios had a meaningful impact on asset allocation decisions, a comparative glimpse of Japans pension industry should dispel any doubts. Figure 32 shows pension allocations for a cross-section of countries including Japan. By 2012, 15 years after Japan fell into deflation, Japanese pension funds fixed income weightings were 20-25% higher than in other countries. Meanwhile, equity weightings were significantly smaller, by around 15-20% of overall assets. As Japan exits deflation, GPIF (Japan largest public pension) has recommended a radical shift away from fixed income and toward equity (bottom of Figure 32). It is unlikely that European asset allocators will consider such a radical shift (away from equity) were deflation to become reality. Still, deflation would challenge a general consensus that equity is cheap and bond yields too low, especially given European asset allocations are not especially overweight fixed income, or underweight equities at least not in a Japan sense.

Eurozone banks have already priced a Japan-style scenario Two key consequences of Japans asset shock(s) and deflationary environment were the marked change in the behaviour of Japanese banks and the significant market de-rating of Japanese banks in absolute and relative terms. In terms of bank behaviour, we highlight two important trends during the post bubble/deflation years. First, Japanese banks purchased a significant amount of domestic government debt. Second, banks shrunk their loan books as demand for credit was weak. This combination significantly

FIGURE 31 Average Sharpe ratio for Japanese assets across inflation regimes

FIGURE 32 Government pension fund allocations and GPIF planned allocation shift

Total assets $bn

2012 Equity Bond Other Cash

Japan 3721 35% 55% 7% 3%

UK 2736 45% 37% 17% 1%

US 16851 52% 27% 20% 0%

Non Jpn 26033 49% 31% 20% 1%

Total assets $bn Equity Bond Other Cash

GPIF (June 2013 allocation)

1212.4 27% 68% 0 5%

GPIF near term target

1212.4 30% 65% 0 5%

GPIF 1-2yr target 1212.4 39% 56% 0 5%

Source: Bloomberg, Barclays Research Source: Tower Watson, Bloomberg, Barclays Research

There is compelling evidence that deflation significantly altered Japanese investors asset allocation mix

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altered the mix of assets on Japanese bank balance sheets over time. As discussed above, overweighting government debt was a rational decision in an environment of deflation and weak loan demand. But given the importance of banks to the economy, the behavioural shift also exacerbated the deflationary trend. Figure 33 shows the evolution of this asset shift at Japanese banks government debt as a percent of total assets grew from 5% in 1998 to a peak of 25% in 2011. Meanwhile, loans fell from a peak of 60% of total bank assets when the bubble burst in 1990, to just 40% today.

Looking at eurozone banks, there is only modest evidence that banks are shifting their asset mix away from loans and into government bonds (Figure 34). Holdings of government debt across the eurozone banking system have risen from a low of 4% in 2008 to around 6% today. This is below peak levels of 8% in 1999 (and clearly well below the peak for Japanese banks of 25%). That said, in peripheral countries where bank stress has been bigger and deflation pressures much clearer, shifts in asset composition have been more prevalent. For instance, government bond holdings make up about 9% of total bank assets in Spain, three times the amount in 2008 (though still below the late 1990s peak of 12%). Moreover, bank balance sheets are shrinking as banks deleverage, which means the actual drop in loans is even bigger than asset shares suggest. Net-net, it is probably safe to assume that banks have added to the deflationary pressures, and may well continue to do so for some time.

A second impact of Japans asset and economy-wide deflation was on absolute and relative valuations for Japanese bank equities (Figures 35 and 36). From a peak of 20% of total equity market capitalization, Japanese banks dropped to just 6% of the total market in 2001, just before Japans FSA, under the leadership of Heizo Takenaka, began an aggressive program to revitalize banks. Meanwhile, price-to-book ratios of Japanese banks fell from a peak of more than 2 in 1993 to barely today still near the cycle bottom despite the clean-up of banks in recent years. On a relative basis, Japanese banks price-to-book ratios are about half of the market as a whole, having been roughly equal at the peak in 1993.

For eurozone banks, valuation adjustments (down) were both early and aggressive. Similar to Japanese (and US) banks, eurozone bank capitalization peaked at about 20% of the market in 2006, then more than halved just three years later. Price-to-book ratios were near 2 in 2006 (same as Japanese banks in 1993), but then dropped to below 1/2 after the collapse of Lehman Brothers. Over the past two years, eurozone bank valuations have improved markedly, but remain well below the peaks of 2006. The stepped-up efforts to recapitalize banks would argue the risks to eurozone bank equities remain to the upside. That said, the experience of Japanese banks over the

FIGURE 33 Composition of Japanese bank assets: Significant shift toward government debt holdings during deflation era

FIGURE 34 Composition of eurozone bank assets: No discernible change in bank asset composition at euro-wide level

Source: Bank of Japan, Barclays Research Source: European Central Bank, Barclays Research

Over the past two years, eurozone bank valuations have improved markedly, but remain well below the peaks of 2006

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deflationary period, despite a significant clean-up of their balance sheets, argues that the risks may be more finely balanced. A very low interest rate environment, coupled with deflation risks and an unfriendly regulatory backdrop will make for a difficult environment for eurozone banks.

What deflation and super low rates would mean for eurozone bank credit is less clear. During the Japan experience, bank credit performed reasonably well, certainly relative to bank equities. Japanese banks were always liquid from excess deposits; therefore, debt performed well. It is not clear, however, that the same capital structure differentiation would occur in Europe. This is because regulators in Europe are more willing to impose losses on bondholders, whereas in Japan this was still taboo. Policies like the Bank Recovery and Resolution Directive and the Single Resolution Mechanism could cause the outcome for European bank bondholders to be much worse off than was case for Japanese bondholders, if a deflationary scenario occurs.

Deflation would likely be an upside risk for the euro One parallel drawn between the present euro-area situation and Japans in the 1990s is the coincidence of a large current account surplus and a strong currency. A common view is that Japans current account surplus was the cause of the JPYs appreciation, which in turn reinforced deflationary pressures.

FIGURE 35 Bank equity market cap as a % of the total market

FIGURE 36 Absolute price-to-book ratio of banks

Source: Datastream, Barclays Research Source: Datastream, Barclays Research

FIGURE 37 Current account balances in Japan and eurozone at comparable points in the crisis

FIGURE 38 EUR/USD FX rate has tracked real interest rate differential

Source: Bloomberg, Barclays Research Note: real 3m differential = 3m interest rates minus 12m trailing inflation

(y/y). Source: Bloomberg, Barclays Research

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