Deflation can have a terribly destructive effect on an economy, which is why ECB head Mario Draghi has been keen to reject the notion that the eurozone's low and falling inflation rates raise the possibility of it occurring.However, Staines notes that peripheral areas are already experiencing deflation, and the issue is going to continue to cause the central bank a headache for some time.
“The whole context of deflation in the eurozone is going to be examined,” he said.
“Whether or not you can define certain parts of the eurozone as already being in deflation depends on the definition.”
“In some parts of the periphery, they are already experiencing negative prices, while in Italy and Spain inflation is below 0.7 per cent, which isn’t great.”
Staines notes that Portugal’s inflation figures were expected to come in at 0.5 per cent but actually came in at 0.1 per cent.
One potential problem for the eurozone is the decision of the German constitutional court that the OMT mechanism, whereby the ECB promised to buy bonds if yields rose above 7 per cent, is illegal in its current form.
Staines says that this could compound the problem if deflation does occur.
The OMT was intended to help when prices of bonds were at 7 per cent, he explains, in a battle against contagion across the region.
But with Italian bonds at 3.7 per cent and Spanish bonds at 3.6 per cent, the OMT is not likely to be implemented.
“Where it becomes relevant is in terms of monetary policy and financing across the region,” he said.
“If we do see a significant move towards deflation, what does it mean for the possibility of QE?”
Staines also thinks that investors have overlooked the weak recent performance of the German economy, which has been so critical to confidence in the eurozone.
“While we don’t expect a big collapse in Germany, the understanding is growth in the country will drag the rest of Europe up with it and if it doesn’t happen there could be problems,” he said.
“It’s ironic how much emphasis there has been towards a very modest slowdown in the UK trajectory, but we are still seeing PMIs at 57 or 58 in the UK, which is strong growth by historic standards. But the slowdown in Germany has gone almost unreported.”
“The implication is there will be far greater divergence within the eurozone – that’s a large risk in the eurozone this year.”
“I would say the two biggest countries diverging at a faster rate is not just a problem for policy makers but for the countries themselves.”
Staines says that his base case is a continued low level of disinflation, but deflation is a real possibility.
Julian Chillingworth (pictured), chief investment officer at Rathbones, thinks deflation is less likely.
“What the eurozone is experiencing is disinflation,” he said.
“The ECB will be working hard across the eurozone to stop deflation. There will be pockets that will see deflation such as Greece, Portugal or Spain.” “That could even be a good thing from an economic point of view. Wholesale deflation would not be good news, but obviously a degree of downward pressure on wages must be positive for them overall.”
“It’s painful at the time but in the long-term it’s a way they will see their economies become more competitive.”
Staines thinks this underestimates the problems in the peripheral economies, and in particular the effect of deflation on debt.
“The flip side is that there isn’t enough growth to make the dent in the outstanding debt, which is 98 to 100 per cent of GDP,” he said.
“Negative prices like we are seeing in Greece make that worse. It is making your path out of debt indubitably harder and longer.”
Chillingworth says that his base case scenario is for a gradual recovery in Europe and the world in 2014.
“We feel that the eurozone economies are beginning to recover into this year and growth for the developed world will be reasonable in 2014,” he said.
“In our view the US is beginning a growth phase and we think US companies should do reasonably well in 2014.”
Mike Deverell, investment manager at Equilibrium, is closer to Chillingworth in his expectations and thinks inflation is a more likely outcome in the long run, although he doubts it will come through this year.
“Inflation expectations are so low,” he said.
“Europe is a special case because certain parts are contracting and are effectively in deflation.”
“In the UK, inflation is so much tied to currency movements and what’s happening elsewhere so it’s difficult to predict what will happen.”
“But I still expect inflation due to the amount of money in the system through QE, Funding for Lending and Help to Buy.”
Deverell points out that the effects can only be seen in house prices so far, but he expects this to change over the longer term.
“If we do see deflation it would impact monetary policy. It will be very negative for the currency and you would want to look for active currency overlay or management.”
Staines says that if a period of deflation does occur, investors would probably want to be in blue chip corporate bonds.
Chillingworth says investors would want to avoid the domestic shares in the affected currencies.
“If you are looking at soft economies, then often you won’t want to look at those economies where the softness is and not buy domestic stocks for instance,” he said.
He adds that investors would want to avoid utility stocks, too, and others where pricing power is important to their business model.
“If you are not getting the benefit of pricing power through a pick-up in prices, utilities would be an area to be wary of,” he said.
Deverell says that it would also be wise for investors to take as much risk off the table as they can.
“If you are in a deflationary spiral you wouldn’t want to be in equities as companies' earnings would be falling rather than rising.”
“What tends to happen is what happened in Japan when government bonds did very well, which would mean German Bunds in this case.”
“If you are getting 2 per cent on a bond and there is deflation of 1 per cent, effectively your return is 3 per cent,” he added.
“It starts to look more attractive.”
For fund picks to protect against deflation, Deverell says he prefers strategic bond funds which can buy government debt if the manager wishes.
He likes the five crown-rated Jupiter Strategic Bond fund and TwentyFour Dynamic Bond fund in the sector.
