U.S. Markets closed

What does low European inflation really mean for stocks?

James Malthus, Macro Analyst

Too-low inflation is a poor environment for economic growth

We can attribute much of the difference in equity performance between the U.S. and Europe over the last five years to central bank policy. Lower inflation than expected can exacerbate sovereign debt issues since it leads to fewer tax receipts and leverage issues as the debt-to-GDP ratio rises since the denominator grows less than expected. The southern European countries are a good example of this issue, as their governments initiated spending plans under growth assumptions that ended up far too optimistic.

The ECB (European Central Bank) cut rates recently in response to inflation figures even lower than expected. The central bank has appeared unconcerned with the deep recession plaguing southern Europe over the last two years, engaging in blame campaigns instead of aggressive stimulus like the U.S. and Japan. Low inflation and growth expectations lead to poor equity returns because businesses don’t invest and consumers don’t consume.

Despite this trend, the mean-reversion trade in southern Europe has been strong

The performance of the stock markets of Ireland, Greece, Spain, and Italy over the past year is a reminder that equities move on revisions in expectations—not necessarily the underlying fundamentals. These markets were mercilessly beaten down in 2012, some to levels below even the 2009 lows. The sentiment-driven rallies in these countries have outperformed even the SPDR S&P500 ETF’s (SPY) 35% run in the last year.

The takeaway for investors is that bull markets can spark in anticipation of fundamental improvements. Spain only emerged from recession in the last month, yet its market has been a leader since mid-2012. These markets still have room to run, but with high potential returns come high risks, as any contractionary posturing by the ECB could tank these rallies in their tracks.

More From Market Realist