The firmness of the euro and customs duties of 15% on EU products weigh on the economic situation. The ECB is expected to lower the rates more than expected, according to Mathieu Savary, by BCA Research.
Disinflation continues in certain regions of the world. In Europe, a risk of deflation threatening, advances Mathieu Savary, chief strategist with BCA Research. Mathieu Savary answers Allnews questions about the perspectives of Europe, the financial markets, the impact of customs duties at 15% and this risk of deflation:
What is the severity of the risk of deflation in Europe?
The risk of deflation has increased in Europe. However, it is not certain that it materializes, especially if the European Central Bank (ECB) adopts a pro-active monetary policy and reduces guiding rates early. My basic scenario presupposes precisely a more accommodating attitude of the ECB which would have the effect of gradually weakening the value of the euro compared to the dollar. The probability of this scenario has increased further after the customs agreement between the United States and the EU.
What do you mean by a deflation? Would a temporary price decline 0.5% be so harmful?
Negative inflation would be very negative because it would mean that interest rates would be 2.5% and would bring a significant blow to growth prospects in Europe. Without response to monetary policy, the probability of entering a very negative deflation and debt spiral would be increased. But I think the ECB will reduce its interest rates
more than you think.
“The equity markets are in a speculative bubble powered by the abundance of liquidity.”
Does the 15% tariff agreement increase this risk of deflation?
Yes, but it does not guarantee it. The hypothesis of a deflation in Europe is based on the combination of prices at 15% and a strong euro. But if a compensatory effect occurs, like a drop in the euro, this risk would decrease. We note precisely such a movement on the currency market. The dollar has been, for a few weeks, again positively correlated to bond rates at two years from the United States. This suggests that the market moves its attention from the trade balance to the interest rate difference. In a context where the Fed is not in a hurry to reduce its interest rates and where, on the other hand, the markets anticipate a drop in rates in Europe, the euro should lower and limit the risk of deflation.
What is your main scenario for the inflation and interest rates of the ECB?
Inflation should decrease to 1% and the BCE key rates to 1.5%. This would therefore result from real rates to 0.5%.
The euro had rebounded this spring, unlike expectations. Does this increase of more than 10% added to customs duties, does not produce an unbearable impact for the European economy?
Effectively. This is why the risk of deflation is real. Especially since the exchange rate of the euro compared to the Chinese currency has significantly increased to reach a higher for more than 12 years. The handicap of customs duties with the United States is therefore accompanied by a negative exchange effect with a major partner. The challenge is all the more complex for the European economy.
This means that European growth forecasts will be revised downwards and that budgetary deficits will be on the rise. It will therefore be necessary to take more savings measures in countries in difficulty, such as France. Are we going to a social and political crisis?
This scenario is correct, but let’s not forget that Germany has just lowered customs duties imposed on its automotive sector from 25 to 15%. Germany therefore benefits, relative to other competitors, from the agreement with the United States. Germany has also increased its budgetary deficits and issued criticism of the EU budget. This fall, we should attend very lively debates between Germany and other member countries which are expected to be resulted in an increase in public spending of the EU.
“We should attend very lively debates between Germany and other member countries which should result in an increase in public spending of the EU. »»
If we consider the reactions of the bond markets to the customs agreement with the United States, we see that no shock has occurred. The yields between the main members of the euro zone are stable. The market is not worried about the prospect of an increase in deficits. Partly, this is due to increased expectations of drops in rates in Europe and an increase in public deficits from the EU.
Is the lack of reaction from the markets rational?
The reaction of the markets is rational. The euro was the asset which was to be the most sensitive to this agreement and it is he who drops. The drop in the euro avoids a major decline in European shares. This is the scenario that has been essential since last April: European actions clearly underperform the S&P 500 index since that date under the effect of an increase in the euro which harms the beneficiary prospects of European companies. The recent drop in the euro is the adjustment that was to occur.
European actions are currently properly carried out because of their correlation with American actions, which beat records, and the drop in the euro compared to the dollar.
Investors were believed to sell dollars assets in the wake of American administration decisions. But the statistics are less clear about it. Large investors continue to buy American titles. What is your analysis?
The scenario of an abandonment of the dollar was widely exaggerated. US markets benefit from unrivaled liquidity. But the dollar movement was logical, if we know that it is the movements involved in the margin that determine the trend. We have gone from a strong attraction for American capital to greater chilling of international investors. This evolution of the feeling was sufficient to cause a decline in the dollar, especially since the greenback was expensive.
This dollar lower movement went too far. Since the end of May, American actions have been outperforming European titles.
I now expect a drop in the euro against the dollar, due to the prices and the prospect of rate reductions in Europe.
Will the drop in rates and the euro make that in the coming months be favorable to European shares?
Exactly. The European European shares index has dropped slightly since the end of February. The drop in the euro would allow European shares to exceed their highest at the end of February. The exporting values would be those which would most clearly benefit from the drop in the euro.
What is your general opinion of actions?
The equity markets are found in a speculative bubble fueled by the abundance of liquidity. The latter are found in the balance sheets of companies and in the richest household accounts, which will benefit, in the United States, tax reductions. The drop in interest rates supports this movement. The expectations related to artificial intelligence fuel this speculative behavior.
We risk observing an American economy which is doing badly but accompanied by a bullish scholarship under the effect of a greater risk taking which would be motivated by the prospect of new rate decreases for the next six months. In the medium term, the United States has greater potential for rate drops, both compared to the neutral rate than compared to other countries.
I don’t think this increase is durable. It will end in pain. But if American actions go up, it is unlikely that European actions do not do it themselves.