Fitch has recently (29th of November) published a report warning that the Eurozone could end up in a Japanese-style stagnation. Weak economic growth, coupled with low inflation could lead the bloc to follow the forbidden path of Japan since the early 1990s. The risks are most acute in Greece, Italy, and Portugal, according to Fitch. Such a scenario could lead to a series of government bond downgrades, Fitch Ratings has warned.
Why is this important?
Japan has lost about two decades to its “zombie economy” since the 1990s. Its stock market has not recovered, the economy did not grow, and inflation remained below target. This lead to interest rates being stuck at zero, Japan taking over large amounts of debt, and the situation not improving much. In case this happened in Europe, this could lead to a lot of economic suffering and even social unrest. In addition, due to its ties to the US, this could also affect the US economy and slow it down.
Many investors, economists, and fund managers see parallels to the Japan’s scenario. Eurozone growth remains low, inflation below target, interest rates below zero, and QE left for an extended amount of time. The German bond yield curve is all under zero. That means investors are not expecting growth or inflation any time soon. In addition, Fitch added that “An ageing demographic profile and the origin of the economic weakness in the global financial and eurozone crises, which were preceded by credit and asset price bubbles and left a legacy of weak banks, add to the similarities”. However, unlike Japan, Eurozone has not experienced deflation.
Japan’s debt grew from 65% in 1991 to 233% at the end of last year. This prompted Fitch to cut its credit rating from AAA to A (5 notches below AAA). Despite having the highest public debt in the world, Japanese yields have stayed very low, largely thanks to huge bond purchases by the Bank of Japan. However, in Eurozone’s case, the ECB might struggle to continue to support low yields due to its 33% rule which we’ve discussed in our previous article. This means it would either have to slow QE down or pursue an expansionary fiscal policy. This would not only stimulate the economy but would allow further room for more QE.
“Differences within the eurozone, fiscal and monetary policy constraints, and strains on political cohesion would make it difficult for the eurozone to escape Japanification, if it were to take root”, Fitch added. If this came to fruition, the implications for traders could be immense. While it is hard to predict what would happen, the possibilities could be endless. The ECB might even decide to manage and invest in the stock market, just as Japan did. So far, however, traders should definitely be on the lookout.