European Open – UK Seen on Brink of Deflation

European indices are expected to open lower on Tuesday, as investors adopt the cautious approach ahead of some key economic data from the UK and US and earnings from JP Morgan and Wells Fargo, among others.

The latest reading of UK inflation will be released shortly after the European open and is expected to show no inflation for the second month running. The UK is extremely likely to fall into deflation territory in the coming months and there is a real chance that will have happened in March.

The main drivers of this are falling energy and food prices, which the Bank of England deems as being positive deflation as it doesn’t tend to alter inflation expectations and instead leaves people with a little extra cash to spend. Core inflation is expected to remain at 1.2% but even at this level it suggests the indirect deflationary pressures coming from lower oil prices could cause a problem in the future. I’m not sure if the BoE is as confident as it appears on the inflation outlook or if it just wants to be perceived to be confident but if we see ongoing declines in the core reading, we may have a problem.

At that stage it’s down to the BoE to resolve it, which as we’ve seen in Japan can be very difficult. And with the BoE not having much room for manoeuvre on interest rates, although many countries have now adopted negative rates, that could well mean more quantitative easing and more liquidity in the financial markets. I imagine that is some way off though at this stage.

In the US, retail sales figures for March will be released and investors will desperately be looking for evidence that consumers are spending some of that extra cash following quite a tight winter period. Three months of declining sales should mean that consumers have plenty of spare cash to give the US economy a lift in the second quarter, now that the bad weather has passed. A 1.1% increase is expected this month and any disappointment will weigh even further on GDP forecasts for the first quarter which have already been revised lower on numerous occasions.

It’s been a long time since I’ve seen investors so worried about an earnings season. Quite often when companies have a rough quarter, the bar is simply lowered to the point that it’s almost more difficult to miss expectations that it is to beat them. Although, in recent years, investors have been willing to accept this because there has at least been earnings growth as a result of efficiency savings and staff cutbacks. This is expected to be the first quarter in six years that we experience a drop in earnings.

One of the most important things about this earnings season is going to be the impact of the stronger dollar on earnings because unlike the poor weather that the US experienced in the quarter, the dollar is likely to remain strong if not appreciate further. Companies need to have an answer to this otherwise we can expect a rough time for exporters and multi-nationals, whose profits abroad are being eroded by the day.

The FTSE is expected to open 6 points lower, the CAC 18 points lower and the DAX 34 points lower.

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Craig Erlam
Based in London, England, Craig Erlam joined OANDA in 2015 as a Market Analyst. With more than five years' experience as a financial market analyst and trader, he focuses on both fundamental and technical analysis while conducting macroeconomic commentary. He has been published by The Financial Times, Reuters, the BBC and The Telegraph, and he also appears regularly as a guest commentator on Bloomberg TV, CNBC, FOX Business and BNN. Craig holds a full membership to the Society of Technical Analysts and he is recognized as a Certified Financial Technician by the International Federation of Technical Analysts.