The euro has been under pressure in the world's currency markets and European assets remain out of f...
The euro has been under pressure in the world's currency markets and European assets remain out of favour, partly because of the flow of good news from elsewhere.
Europe has been unable to attract investors' attention despite its continuing low inflation, reducing budget deficits, a trade surplus and signs of a revival in output. As a result, the euro has fallen in value to become highly competitive in trade, providing the opportunity for an export-led recovery among the euro-11.
Interest rates are still low at 3% and Europe has built up a considerable stock of excess liquidity since 1995. Much of that remains in the financial system as the wider money stock has grown at only half the double-digit rates recently recorded by the narrow money stock. Such surplus liquidity has tended to stimulate economic activity after a year or so, supporting the evidence from surveys that the European economy may be strong next year.
If global activity picks up, investment is likely to be buoyant, particularly in Asia where companies have been very restrained in their spending for the past few years. Germany and Italy are beneficiaries of investment spending: an upturn in that cycle would be especially helpful to these rather depressed economies.
If the outlook for European growth is for improvement, some deterioration in the inflation prospect might be expected. However, there has been a clear improvement in Europe's inflationary environment since the mid-1990s. Despite the long acceleration of monetary growth since 1995, the rate of inflation has halved. That trend is probably due to the competitive pressure applied by the single market, along with more general pressure on prices from technological advances and more intense global competition.
However, the rise in oil prices and fall in the euro's international value have reversed that long decline this year, and inflation may edge up further as these factors continue to operate. That suggests the ECB will raise interest rates further, perhaps returning rates to their normal relationship with inflation. That might depress financial markets while curbing inflation, but would help the ECB gain credibility.
The Bank of England immediately convinced markets of its political independence by taking the unpopular decision to raise interest rates in 1997.
Persistently high unemployment is a painful side-effect of the drive to efficience but that drive ensures that profits can continue to grow even in the disciplined financial environment which allows share prices to stand at a high multiple of those earnings. Investors can expect to benefit across the range of European assets as Europe's institutions gain credibility over the year ahead.
Nigel Morgan is economic strategist at Old Mutual Asset Managers
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