The European Union financial struggles are not confined to the spectacular problems of the Greek Economy. The Global Financial Crisis (GFC) highlighted the precarious state of Eurozone Government finances, most notably in the remainingPIIGS – Portugal, Ireland, Italy, and Spain, which has forced a series of important austerity reforms to reduce government largess (spending) and improve the bottom line for these economies.
It is now 7 years since the GFC and Europe is still shaking the effects of its debt-fuelled hangover. While some of the PIIGS have made impressive Budget repair, Europe still faces muted economic growth as well as deflationary risks.
Deflation is the opposite of its much better known and more common sister, inflation. Just think of a balloon.
Deflation is where prices of goods decrease overtime. Therefore, instead of your grocery shop costing a little bit more each year, it costs a little bit less.
Not when you owe money – which has been the PIIGS of Europe’s problem.
If you are getting less money for the goods you sell, you will have less money to pay your debts which are still accruing interest. It also doesn’t help if people put off buying your wonderful products because they know the longer they wait the cheaper your products will get.
High unemployment is also a contributing factor. You might have just lost your high paying job, and quickly taken another low paying role as it was the only option. This is how deflation can track into wages and services too.
So you can see why deflation becomes a trap, as deflationary economies find it hard to attract investment. Low investment acts like a handbrake for all economic activity, compounding the original problem.
An interest rate curve is as simple as plotting the interest rate of an investment over time (the term). The “shape” of the curve can be positive (lower shorter term rates), flat (short term and longer term are about the same), or negative/inverted (shorter term rates are higher than longer term).
The shape can be an important tool in analysing the state of an economy. Market participants like big pension fund managers will expect to get a higher interest rate than the one offered today if there is inflation (positive yield curve). If deflation exists, shorter term rates are usually higher, and the yield curve can be negative in shape. The shape of the curve will therefore indicate possible future interest rate changes and perceived changes to economic activity.
This is an example of the interest rate curve for the European Bonds with a term out to 30 years. Its shape is considered ‘normal’ because longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.
Quantitative Easing is where the central banks work to increase the money supply by purchasing a specified amount and type of financial products from institutional investors such as banks, pension funds and the like. Depending on the central bank and their program, it could include covered bonds, semi-government authority debt, mortgage backed securities, other sovereign debt issues etc.
In January, the European Central Bank announced that it would purchase €60 billion of financial products a month. This announcement caused Nestle’s corporate short term bonds to temporarily hit -0.004 in February. This debt issue epitomized the insanity of QE. Instead of investors getting a positive return on their investment, they were in effect paying Nestle to take their money. With so much cheap or even “free” money, companies have been active in investment. Wait… isn’t that the intended effect of these programs?
Share markets exposed to central bank QE have done very well, as have the share market investors. However, there’s a new problem looming for some of these companies; low interest rates are putting pressure on company profits because of one big factor – pension schemes.
There are two main types of pension funds, defined contributions and defined benefits. A defined contribution pension is where the employer agrees to pay a certain amount into a fund, and then the employee gets this money and its interest upon retirement. In Australia, this is the most common pension/superannuation fund type. Employers pay 9.5% of the employee’s wages into a fund, and then that fund invests to grow the employee’s balance over time.
Defined benefits pension funds work by guaranteeing the employee a certain income upon their retirement. It is usually based on a formula that includes the length of membership in the fund, an accrual percentage, and a final average salary. Employers therefore have to ensure that there is enough money put aside to meet their pension obligations when an employee is entitled to them. Companies manage this by putting money aside into funds for their future pension payments, similar to what the Australian Government did with the Future Fund. Defined benefit funds are more common in European countries.
When a defined contribution scheme invests, they invest in a mix of assets such as bonds for fixed income characteristics, and shares for growth. If the share market has a bad year and triggers a negative return, then members of the fund will probably get a negative return that year. A member’s balance can shrink.
Defined benefit schemes on the other hand might invest in the same mix of assets which generate the same return… but they’ve still got a commitment to pay the member a percentage of their wage.
The problem is compounded at the moment. Think back to the Nestle interest rate example, or even consider how 10 year Euro bunds fell as low as 0.07%. European company pension schemes may not be earning enough to fully cover the future pension obligations. This means they may have to set aside more money out of the company operations. Less profit (possibly even losses) means less corporate investment and smaller (or no) dividend payments. Lufthansa being a good case in point.
Lufthansa recently reported an operating loss of €133m for the first quarter. Their defined pension plan obligations blew out to around €10 billion. This forced the German national carrier to cancel dividends and set aside more capital to address its ballooning pension obligations. The problem is not limited to Lufthansa or German companies. It’s estimated in the UK that FTSE100 companies have a £80b deficit looming.
What can be concluded from this is that defined benefits schemes were not incorporated in the original cost of labour in years/decades gone. Companies are now trying to balance investments in products and processes with growing pension liabilities compounded by low interest rates.
Cheap money might (like a good night out) sound great. However, the morning after always brings a new perspective.
