Despite recent rises in the consumer price index, the eurozone economy has too much slack for inflation to structurally move above the ECB’s target of just under 2%, says Aegon Asset Management’s Multi-Asset portfolio manager Jordy Hermanns.
Spot inflation in Europe has risen this year from the deflationary levels reached during the pandemic. The annual change of the consumer price index rose to 1.6% in April, the highest rate in two years. Three eurozone countries reported headline inflation levels at- or above 2% in April, including Germany. Another four eurozone countries reported inflation between 1.5% and 2%. Market implied inflation expectations have risen as well, coinciding with improving medium-term growth prospects for the eurozone economy on the back of the vaccination rollout and economic recovery.
However, Hermanns believes this upswing will be transitory, with structural headwinds for inflation likely to assert themselves in the medium term. That said, it’s likely that we see a further rise of eurozone inflation in the coming months.
“The pickup in spot inflation can be explained by transitory and technical factors, including the reversal of a German VAT reduction and changes to the weighting of products and services used to calculate inflation, which will naturally fade out,” he says.
“We expect that inflation in the eurozone will be elevated in the coming months – possibly even overshooting the ECB’s target for a short period – on the back of a cyclical upswing around the reopening of the economy as well as via higher energy base effects and technical factors. Especially German inflation numbers could grab the headlines as inflation in the eurozone’s largest economy can move further above the ECB’s target later this year. This could place the ECB in a difficult position in case the central bank wants to lengthen or increase its PEPP buying program.”
However, the multi-asset team’s medium-term base case is that inflation will not structurally move above the ECB’s target.
“We think there is slack in the eurozone economy, which is a strong headwind for persistent inflation,” he says.
“Structural inflation would require the economy to operate at or above full capacity. In such a scenario full employment could result in wage growth which could translate into higher inflation. The eurozone economy is still far from full capacity and wage growth is modest.”
Besides the slack in the economy, other long-term considerations will mitigate against higher inflation, adds Hermanns.
“There are also structural factors that act as a gravitating force that will keep inflation low, such as the shrinking working population in many eurozone countries, low productivity growth and cost reductions on the back of technological advancement.”
While the chances of structurally higher inflation are limited, the multi-asset team warns that any inflation is nonetheless a concern for investors.
“The current combination of low yields and high valuations is likely to result in lower returns compared to the recent past for typical investment portfolios,” says Hermanns. “The low return outlook implies that investors face a lower and flatter efficient frontier compared to the prior 15 years. In a real return sense, even moderate inflation will erode purchasing power at current interest rates.”