Good Example Of Assessing The Euro Area Risk Of Deflation Essay
The Euro Area is now at a critical point of its existence, due to the conjecture of two factors. Firstly, the sovereign debt crisis of 2011 endangered Euro countries as it exacerbated the structural weaknesses and debt levels of peripheral countries such as Greece, Spain, Portugal and Italy (also referred to as PIGS in the academic literature). Secondly, the central banks worldwide have been entering into an area of “free money” by lowering interest rates to levels not seen before, and by launching quantitative easing programs (referred to as QE). The uncertainty comes from the fact that these policies have never been experienced before, and never at such a massive scale: the ECB itself launched its first QE program in January of this year (European Central Bank, 2015). Our focus will thus be on presenting macroeconomic data. Firstly, this will allows us to discuss current risk of deflation in the Eurozone. Secondly, we will link this discussion to the perspectives for employment and economic activity in the Euro area, because full-employment ultimately is the goal of monetary policy (and quantitative easing is solely an unconventional measure to reach monetary policy objectives). Thirdly, we will look at the financial fragmentation of the Euro area, caused by differences between member countries and describe the monetary policy we deem most appropriate.
Economic data about the Eurozone
The ECB provides extensive statistics and information about macroeconomic indicators. The most recent data available is to be obtained from its Statistics Bulletin as well as the charts generated from this data (European Central Bank, 2015). Below is included the inflation rate per country as of March 2015. As can be seen, inflation rates vary widely between countries: Romania and Austria show inflation rates of respectively 0.8% and 0.9%, while on the other hand Greece and Cyprus both report deflation rates of -1.9% and -1.4% respectively. Having a look at the distribution of the results shows a large disparity between countries. Hence we can reach a first conclusion with regards to our problematic: the risk of deflation in the Euro area is highly country-specific. It is therefore hard to assess “the risk of deflation in the Euro area” without discussing specific countries.
This fact proves challenging for setting an appropriate response to structural problems: as situations and risks are country-specific, measures such as monetary policies are applied to all countries of the Euro area. It is thus not possible to “fine tune” these policy changes for the specificities of a particular geography or particular group of countries. It is not surprising to expect that it would be advantageous to apply different monetary policies for the PIGS countries, whose problems are exacerbated, compared to more stable countries as Germany. Overall, we can observe that countries with inflation only experience relatively moderate levels of inflation (i.e. under 1%) while countries experiencing deflation report strong decreases: Poland and Cyprus see decreases greater than 1%, while Greece almost reaches a decrease of 2%. This analysis of the data highlights an asymmetry between positive and negative rates of inflation in the EU: countries with negative results have more impact that countries with positive results. We therefore assess the risk of overall deflation as relatively strong, with the expectation that it would be driven by specific countries overall, thus not driven equally by all countries in the Euro area. The highest perceived risk of course comes from Greece, which recent political changes and negotiations notably with German creditors have been widely publicized in the press.
As we have shown, inflation varies widely on a per-country basis. One factor linked to inflation is the exchange rate. In the case of the Eurozone, a particularity is the common currency: since all countries use the same currency, they cannot adapt the exchange rate to suit their own particular situation. Please see the chart below for a representation of exchange rates from Eurostat:
This chart represents the variation of exchange rates of the main currencies (the Chinese Renminbi, the US dollar and the pound) with regards to the Euro. For the sake of comparison they have been rebased at 100 at the start of our sample period. We observe that between June 2014 and March 2015, the Euro depreciated against all three major currencies listed. It depreciated by c.a. 10% against the pound, and by c.a. 20% against the US dollar and the renminbi. This result makes economic sense because currencies depreciate as their rarity decreases: low interest rates (cf. page 3) create cheap money and quantitative easing also increase the amount of currency available. The implications for the Eurozone and inflation are that as the Euro devaluates, exports become cheaper for persons holding pounds, dollars or renminbi. Therefore, exporting countries of the Eurozone such as Germany, France and more recently Lithuania greatly benefit from this currency effect to boost their economies, potentially fighting deflation. The implication for our forecast is that the exchange rates momentum we observe protects the Euro area economy from worsening – because the devaluation of the Euro is helping exports. Would the Euro be much higher, strong exporting economies in the Eurozone would suffer, which would probably increase the risk of deflation. Since exchange rates are linked to interest rates (and by extension to the current quantitative easing), we will be monitoring changes in policy to measure how this aspect is likely to evolve: considering the mechanism explained above, any revaluation of the Euro could lead to adverse effects. For the sake of comparison, one can take a look at the United States where this situation is currently happening: the FED is promising increase in interest rates and the end of its quantitative easing programs, which triggered the revaluation of the US dollar.
Perspectives for employment and economic activity
While monetary policy is designed to influence inflation, the job market and employment conditions are ultimately the most important point to focus on because price inflation requires companies to produce new goods and grow. In order to attain this goal, they need to recruit an available and qualified workforce. The latest data communicated by the ECB dates from February 2015 and can be observed in the charts below:
As can be seen from graph C30, the employment in terms of persons employed and hours worked have experienced strong fluctuations during our sample period. Overall, we notice that the 2011 sovereign debt crisis caused a 1% annual decrease in the number of persons employed, and a more than 2% decrease in hours worked. However, since bottoming in 2012/2013, we saw a positive increase in both persons employed and hours worked, which are both now experiencing a 1% annual increased. This fact is correlated to graph C31, where we can see that the employment rate decreased to less than 11.5%, after topping at slightly more than 12% in 2012/2013. These results mitigate the ones we saw in the previous graph: while there is deflation in some countries of the Euro area, we can see that overall employment is improving, which gives confidence for a positive evolution of inflation in these countries. The obvious setback with this data is that they represent the overall Euro area: for the reasons mentioned above, we would greatly benefit from employment data on a per-country basis. Particularly, we would focus on Greece’s employment data, since it has the potential to trigger unwanted contagion in the Eurozone.
Financial fragmentation and opinion about appropriate policy
The financial fragmentation of the Eurozone has been increasing in the past few years. A qualitative way to observe this phenomenon is to observe the occurrence of specific terms in the news, such as “structural problems in Europe” or “Grexit” as well as “euro breakup”. While some problems appeared after the Lehman crisis in 2008, it was the Sovereign debt crisis in 2011 which exacerbated problems in European economies, as can be seen from the data provided above. Nowadays, the Eurozone could roughly be divided in two groups: healthy countries including Germany, which have strong employment, trade balances and stability, and peripheral countries such as Italy, Portugal, Greece and Spain, which the academia dubbed “PIGS”. PIGS countries are in a difficult situation and their future depends on tensed negotiations with creditors (thus principally Germany) and the promise of financial reforms and austerity measures. The biggest threats leaders see is the glooming deflation because it would render debt repayments of indebted countries much more burdensome and could threaten the stability of the financial system: handling fixed interest payments becomes harder if income decreases, because employment decreases and tax collections decrease. In other words, because the value of debt rises with deflation, the debt becomes more burdensome for borrowers, which only benefits lenders. The problem is that the higher spending on debt by borrowers will decrease their spending on leisure and normal consumption, which will call demand to fall. If demand falls, prices will fall, leading to more deflation: this is why deflation is often described as a spiral. Moreover, consumers delay purchases when price falls because they expect they will be able to obtain the same goods at a better price in the future, thereby increasing the tendency for prices to continue falling.
The monetary policy is limited to help in this regard, because fostering inflation works when there is a margin to decrease interest rates. In the current environment, this “margin of safety” disappeared as interest rates are maintained at zero or near-zero levels. Therefore, conventional monetary policy becomes ineffective. Comparative data about interest rates can be found on Eurostat’s website, and yields the following graph:
Note that interest rates in the UK, US and Japan have been included for comparative purposes, and do not experience similar decrease, putting in perspective the current policy of the Eurozone with its peers. As can be seen, the current short-term interest rates in Europe are indeed nearing 0. It is also notable that the Eurozone represents the largest decrease over our sample period, losing more than 20bps (from May 2014 to March 2015). Over the sample period, the monetary policy of the Eurozone was therefore the most aggressive among its peers.
In this regard, we believe that a Quantitative Easing program is the most appropriate response: the ECB will be purchasing bonds issued by central governments. The rationale of having the central bank purchase bonds is that it will increase the prices of assets in the markets, thereby creating a wealth effect. The wealth effect dictates that people, feeling richer, should be compelled to spend more which would energize spending and the economy. This is to be considered in conjunction with the level in interest-rates: as yields on deposits and treasuries are very low, investors transfer their funds to riskier assets in financial markets, such as bonds and equities. It is to be noted that the correlation between QE, the wealth effect and spending has not been proved, since it is virtually the first decade that our world experiences full-fledged quantitative easing.
An important caveat is that the quantitative easing program is currently the most appropriate choice, yet it is so because traditional monetary policy – i.e. the change in interest rates – became ineffective. As interest rates are hovering near zero and can even be negative, how could further decreases have an impact? An important tail risk comes from the fact that consequences of quantitative easing measures over long periods of time are virtually unknown. We remained concerned as the quantitative easing program in the US was followed by asset price inflation, yet signs of growth pickup remain to be seen. In other words, while the quantitative easing programs did cause asset price inflation as anticipated, the correlation between higher asset prices and higher spending is missing. In Europe however, as the graphs above show, we are already noticing a pick-up in employment rates, sparking optimism. These key variables need to be followed upon and analyzed, as it is not excluded that effects of quantitative easing programs differ between Europe and the United States. While it is too early to comment on this, European data after the end of the ECB’s quantitative easing should help us shed more light on this relationship.
Analysis of the French retail sector
In this section I will focus on providing an analysis of the French retail sector over the period 2010-2014. To gain insights into this market, I take a look at three French firms, namely Leclerc, Carrefour and Auchan. Because only Carrefour is a publicly traded entity, financial disclosures are limited; nonetheless financial information such as revenues in the French market and occasionally operating margins are available – which we use as a base for this analysis. I will first present the three companies and the French retail market. Then, I will analyze the key drivers over our sample period among all three firms. Thirdly, I will provide financial projections and outlook guidance for the years 2015 and 2016, including possible bull and bear scenarios. Finally, details about the financials and additional data can be found in the appendices.
French retail players
Leclerc is a firm founded in 1949 in France. It is a food-oriented retailer which now owns close to 700 shops – almost 600 of them are in France, with the reminder in European countries such as Poland, Italy and Portugal Although it owns store abroad, Leclerc always had a strong focus on the French market, where it realizes most of its sales and where it has the vast majority of its assets tied in. Its footprint in the French retail market is important, since in 2014 more than 18,3M households visited a Leclerc shop at least once, a figure which increase d 2.8% year-on-year (Leclerc, 2015). Leclerc is a private company, yet press releases provide adequate financial information for the purpose of our analysis.
Carrefour is a retailer founded in 1960 in France. Its product offering is wide (i.e. not only focused on alimentary products – but also electronics, etc). While Leclerc is a European group, Carrefour has a stronger international focus: it owns stores in Europe, South America, the Middle-East and Asia. Carrefour is an iconic brand because it is the brand that brought the first hypermarket in France in 1963. It now owns more than 1200 hypermarkets and more than 10000 shops worldwide. Carrefour’s annual reports provide extensive information about the French results of the firm, especially recurring operating income per country.
The last food retailer mentioned in this analysis is Auchan. It is the largest retailer in France after Carrefour by number of shops, and was founded in 1961. Similar to Carrefour, it capitalized upon the emerging hypermarket trend occurring in France in the 60s: today, it generates approximately 80% if its sales from hypermarkets. The product offering is also larger than Leclerc, since it also includes apparel, electronics and diverse products on top of food retailing. Auchan is a global brand, being established in Europe and in Asia. Groupe Auchan is a private company, yet detailed financial statements were available for the purpose of our analysis.
Other players in the retail market include brands such as Intermarché, Super U, Lidl and Cora. Nonetheless, our sample takes into considerations the largest and most iconic brands. In a concentrated market like the food and retailing markets, the large players dictate the rules while the smaller players have a minor influence. Therefore, the fact that they are not included in the sample does not constitute a bias – we deem their effect as negligible.
French retail market
As can be seen from the following chart, the French retail market is relatively concentrated, the bulk of the volume being shared between the biggest players. Since the emergence of large players in the 1960s, most of the market share has been consolidated among a few players which include the three companies mentioned, as well as others such as Intermarché and Lidl. Therefore, the large players benefit from scale and enjoy most of the profits, while the smaller players have to compete on niche markets or struggle to reach critical size.
It is worth taking a closer look at Lidl to understand how the French retail market has been changing over the last few years. While founded in 1930 – and therefore being older than all French brands mentioned above – Lidl only developed strongly in the 1970s, opening its first hard-discount shop in 1973 in Germany. It entered the French market in 1988 with a new strategy: offering a very minimalistic store concept with the goal of offering the lowest prices possible and therefore undercutting competition. Lidl has since steadily gained market share (reaching 4.7% at the end of 2014 as can be seen from the graph above), and the market has evolved towards two very different strategies. The differentiation strategy is being practiced by players like Leclerc, whose goal is to offer a wide product offering, with food, electronics, apparel: in essence, being a one-stop shop for customers. On the other hand, Lidl and its hard-discount strategy appeals to low-income families who desire low-cost food products. Little is known about the firm since it does not publish financial statements. Hard-discount has been a trend which had a strong impact on the French market, and similar developments have been observed recently in Europe, where Aldi and Lidl are disrupting Tesco’s historical dominant position. Aldi’s value proposition of providing food at the lowest cost possible is so efficient that they managed to make Wal-Mart leave Germany because they could not compete. This obviously has implications for the French market where Aldi/Lidl are also present.
The following graph is a representation of the respective sales of our three sample firms over the period. At the end of 2014, we can see that Carrefour had net sales of €35.3 billion, Leclerc had net sales of €34.5 billion (excluding fuel sales) and Auchan had net sales of €20.3 billion. Combining this information with the market shares presented in the first graph, we estimate the French retail market to be worth north of €140 billion. This figure has been steadily growing over the last few years, driven by growth in sales of our three players. The most impressive growth comes from Leclerc, which grew sales at a compounded annual growth rate of 4.8% per year (excluding gas sales). Other players show much slower growth, with Auchan showing a compounded annual growth rate of 1.0% per year and Carrefour showing almost flat sales with a 0.3% compounded annual growth rate. Overall, the share of these three players grew at an average compounded annual growth rate of 2.1% - their combined sales now representing more than €90 billion. This highlights two facts: firstly that in the long-run sales of food retailers will move hand-in-hand with the GDP growth rate. Second, it confirms that the French retail market is relatively consolidated.
Trends in the French food retailing have been long-lasting, spanning over several years. Since the 1990s (which coincides with the entry on the market of hard-discounter such as Lidl), two main trends have been observed. While these trends started much before our sample period, they are the key drivers of the market during our sample period. The first trend is the permanent increase in the number of stores (Tarteret and Hanne, 2012) over the French territory, both for hypermarkets and supermarkets. The second trend described in the same study is the increase in the sales areas of these shops on average: put another way, shops in the French market are getting larger. Looking at the specific breakdown, we can see that hypermarkets sales areas are actually decreasing, while supermarkets sales areas are increasing. Therefore, we have been observing a shift in power from hypermarkets to supermarkets.
One could argue that opening more shops would be making prices more competitive and therefore would lower revenues and growth. However, empirical evidence shows that this was not the case: opening new stores allowed to respond to existing demand in the catchment area. Moreover, store growth does not have the same implications for differentiators and hard-discounters: while hard-discounters target price-conscious customers, differentiators such as Carrefour gather new clients by providing a different offering, so by default their customers are less sensitive to price changes.
A last factor affecting growth was the economic conditions in France. During our sample period, growth in France was mostly positive – although slower than before the sovereign debt crisis of 2011. Please see the following chart:
As can be seen from the graph above, data from the INSEE shows GDP growth hovering most of the time around 0.2% per quarter, peaking at 0.6% in 2013. While a deterioration of economic conditions would benefit hard-discounters, better economic conditions and more appealing fiscal policies in the country for most families benefit shops with a differentiated strategy such as Carrefour. This is due to the fact that people with more income will shift their consumption towards normal goods (such as quality food, TVs, electronics) while people with lower incomes will shift their consumption towards inferior goods (such as entry-level brands, pasta, etc.) typically sold by discounters. Therefore, as we mentioned that there is a power balance shifting between hypermarkets and supermarkets, we must reckon that there is also a power balance between differentiation and hard-discount strategies, which are influenced by economic situation and available income. A final point to be mentioned is the availability of cheap money, with interest-rates being at historical lows and the recent Quantitative Easing program launched by the ECB in January 2015. This point was discussed extensively in the first part of the paper. Available credit allows consumers to purchase more, and allow firms to expand and fund capital expenditures, it is therefore critical for an economy to grow and prosper.
Forecasts and outlook
Our financial forecasts assume two macro cases: one bull case and one bear case. Firstly, we assume a first scenario where growth is favored by economic conditions: we assume that the Quantitative Easing policy of the ECB is successful and that it successfully creates a wealth effect in the French market, increasing consumption. Our bear case considers a tightening of available credit and worsening of economic conditions, effectively yielding the opposite outcome. A successful monetary policy should enable a 1.0% premium growth on top of the recent growth rate of 2.1%, giving an annual growth rate of 3.1% for the sector: this would bring total net sales of our three players to €92.9 billion in 2015 and €95.8 billion in 2016. However, adverse scenarios are not to be excluded. A bear case forecasting a growth of 1% in 2015 and a decrease of 1.5% in 2016 would yield a total 2016 net sales amount of €89.6 billion, lower than the current sales level. A point concerning the assumptions of these forecasts needs to be made. While many factors could influence sales at the group level (i.e. change in geographic mix), we are here only looking at French sales and of food and basic consumption products, for instance excluding fuel products. Therefore, demand and supply dynamics are much simpler to forecast and mainly focus on expected growth rate in both the population and the economy.
European Central Bank, (2015). ECB announces expanded asset purchase programme. [online] Available at: https://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html [Accessed 19 Apr. 2015].
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Leclerc, M.E. (2015). “Nous avons fait une des deux plus belles progressions du marché en 2014“. LSA-Conso. [online] Available at: http://www.lsa-conso.fr/michel-edouard-leclerc-nous-avons-fait-une-des-deux-plus-belles-progressions-du-marche-en-2014,200362 [Accessed 17 Apr. 2015].
Tarteret, O. and Hanne, H. (2012). The mass food retail sector and economic growth in France. DGCCRF - Eco. [online] Available at: http://www.economie.gouv.fr/files/directions_services/dgccrf/documentation/dgccrf_eco/english/DGCCRF_eco11_mass_food_retail_economic_growth_France.pdf [Accessed 19 Apr. 2015].