Deflation is one of the biggest phobias for central bankers. I am particularly stressing asset market deflation, which central bankers are highly concerned about. I had discussed the most important reasons for this concern in one of my earlier articles. In this article, I will be discussing the relatively high deflation fears in the eurozone and the possible action by ECB to prevent asset deflation. I am of the opinion that ECB might launch another round of the QE program relatively soon in order to prevent a deeper recession and deflation.
One might argue that the ECB has recently announced the OMT program and there is little likelihood of another QE. However, it is important to understand that the ECB's OMT program is focused on helping the PIIGS countries to reduce their bond yields and hence their interest payment burden. Further, the OMT program is a completely sterilized program and should not have an expansionary impact on the central bank's balance sheet as the Fed's QE3 will. With the OMT program not flooding the system with liquidity, the fears of deflation might increase amidst a recession in the eurozone, which might get worse in the foreseeable future.
The point I am trying to make is clear from the three charts given below from the IMF world economic outlook report.
As the first chart shows, the probability of prolonged recession is the highest in the eurozone. I do believe that the eurozone is already in a recession and the recession might last for a few quarters as the core and peripheral economies struggle. The core eurozone economies were supporting growth at relatively high levels. Currently, even Germany seems to be headed for a meaningful slowdown. The probability of a sustained deflation is also higher in the Euro area as compared to the United States. I have to mention here that the United States might witness moderately high inflation from here on instead of any prospects of deflation. I also have to mention that the deflation fears include asset market deflation. Else, readers might feel that deflation fears seem exaggerated considering the fact that the Euro area headline CPI was 2.6% in August 2012. The deflation vulnerability index also segregates the eurozone countries from the rest of the world. As evident from the third chart, the deflation risk is low in the world while it is high for Greece and Spain with Ireland having moderate deflation risk.
The money supply growth in the Euro area has also been moderate as compared to the United States since mid-2009.
The Money supply growth in the Euro area has trended similar to the money supply growth in Japan. I am of the opinion that the ECB might push for another QE program aimed at improving the money supply growth in order to calm down the fears related to deflation. Further, from a policymakers perspective, it might also help in boosting economic growth, which is in the negative zone. In my view, any such easing program might just prop up the economy for a few quarters before anemic growth returns.
Also, the fear of deflation is exaggerated and advanced economies might witness inflation in the long-term as the growth in money supply has an impact on asset prices and commodity prices with a lagging effect.
Considering and expecting this outcome, I do believe that the asset market correction over the next 2-3 months might be a great time to consider exposure to risky asset classes and precious metals. I mention as correction over the next 2-3 months as equity markets have trended higher significantly in the near-term.
Investors can consider exposure to physical gold on every correction. The gold ETF is also a good option for near to medium-term and investors can consider exposure to the SPDR Gold Shares (GLD) ETF. The investment seeks to replicate the performance, net of expenses, of the price of gold bullion. Index investing might be a good idea and investors can consider exposure to the SPDR S&P 500 (SPY) ETF, which seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index. I also expect emerging markets equities to outperform developed market equities over the long-term. Excess liquidity creation in the advanced economies might help asset markets in the emerging economies with higher GDP growth and companies with relatively robust growth prospects. The iShares MSCI Emerging Markets Index Fund (EEM) is a good option to invest in emerging markets.