Markets

Why is producer price inflation so important for eurozone companies?

With prices rising again in the eurozone, we look at what this means for company profits.

24/07/2017

Emma Stevenson

Investment Writer

“The threat of deflation is gone and reflationary forces are at play” - Mario Draghi, President of the European Central Bank, at the ECB Forum on Central Banking, Sintra, 27 June 2017.

The spectre of deflation that had been hanging over the eurozone has lifted. Deflation in an economy occurs when the price of goods starts to decrease.

This may seem like good news for consumers but it is a sign that economic conditions are deteriorating.

During periods of deflation, companies have to cut their prices, which puts pressure on their profits. In turn, this means they are less able to invest in their businesses and may need to cut costs, for example by lowering wages.

This can create a spiral of reduced demand, lower prices and further cost-cutting.

Eurozone producer price index is no longer negative

Eurozone producer price index chart 

The chart above shows that deflation of producer prices – sometimes referred to as factory gate prices – is at an end. Prices started rising towards the end of 2016 and have largely been on an upward trend ever since.

Higher producer prices are very important for companies as they pass these on to consumers. When prices are rising, consumers will make purchases earlier as they expect higher prices in future. If they expect prices to fall further, they will delay purchases.

Assuming costs stay the same, higher sales prices result in an increase in profits for corporates. Higher profits can then be reinvested into the business or paid in dividends to shareholders.

View from a fund manager – Martin Skanberg, European equities, says:

“After a period of weak demand, companies in the eurozone are now in the favourable position of enjoying both volume growth and price growth.

“The two together should lead to a substantial pick-up in profit margins. In Europe, profit margins have been depressed for some time and have lagged far behind US levels.

“Overall, the economic backdrop for the eurozone looks encouraging. Forward-looking indicators are robust and unemployment is gradually edging down.

“There are perhaps a few clouds on the horizon in other economies, notably the US and China where the credit impulse (the change in the growth rate of aggregate credit to GDP) is now negative.

“We currently favour those companies that are exposed to the ongoing economic recovery in the eurozone, although we will continue to buy globally-exposed firms where we feel the valuation looks attractive.”

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