Deflation, Not Debt, Is The Concern

Positive news emerged last week as the Eurozone revealed its deficit had lowered to match the EU target, while the UK's deficit turned out to be at its lowest level since the financial crisis.

But the cost of the credit crunch is rising. This is because while the rate of deficit – the difference between the governments spend and what they earn – is gradually falling, the overall debt is rising as we continue to borrow each year, even if it is a smaller loan.

Renowned investor and chief economic officer at Allianz, SE Mohamed A. El-Erian wrote in Bloomberg on Wednesday that normally a country can only fully emerge from a financial crisis if its solves not only the "stocks problem" – secures a flow of money to cover its immediate needs – but also the "flows problem" – a way to manage its outstanding debt over time.

"In Europe today, this conventional wisdom appears to be fading," he wrote. "The temptation there is to declare victory having solved only the flow, not the stock, challenge."

A quick scan of the Eurostat figures is here.  While the Eurozone government deficit fell from 3.7 percent in 2012 to 3 percent in 2013 of gross domestic product (GDP), the total government debt continued to rise from 90.7 percent to 92.6 percent. The government debt is way off target – the so-called Maastricht limit is only 60 percent.

Break it down to a country level and a true hodgepodge is revealed.

While Germany's deficit came out the healthiest – but still saddled with 78.4 percent debt – France struggled to meet its 3 percent deficit target (currently at 4.3 percent) while Slovenia shot ahead to 14.7 percent deficit. Greece, only just returning to growth after a six-year recession, has debt amounting to a whopping 175 percent of GDP, according to Eurostat.

Inflation is the real issue

But all this talk of debt and deficit – and potentially getting confused between the two – distracts the investor from the real issue in Europe, which is (lack of) inflation.

The latest reading of 0.5 percent inflation in March is unlikely to kick start the economy or help countries to inflate away their debt mountains.

There are several ways to play the deflation battle, including small and mid-cap European equity exchange traded funds, inflation-linked and conventional corporate bond ETFs.

Lucy Walker, fund manager at Sarasin & Partners, said deflation can kill even the strongest-looking recovery. She expects European Central Bank president Mario Draghi to implement more quantitative easing (QE) in the future.

"Will Germany let that happen? According to our communications with the Bundesbank, the Germans are softening their view so we might see QE later this year from Europe," she said.

UK: Better underlying dynamics?

Walker said the UK still has better underlying dynamics than Europe.

"In Europe there is always this dichotomy between different states, with rates on one level for the periphery and another level for Germany," she explained. "The UK government has done a reasonable job trying to get things in control but growth has exceeded what they thought it would. If unemployment continues to fall inflation should pick up, albeit with a bit of a lag."

(You can read a full interview with Lucy Walker here.)

We are unlikely to see rates rise in the near future. The BoE voted to maintain interest rates at 0.5 percent on Wednesday and no more money printing for the time being.

However, the good news from the UK that we read at the start of this article – that UK deficit is at its lowest since 2008 – turns a bit bleaker when you realise it is still much higher than some other advanced economies. This is because, pre-crisis, the UK used to rely heavily on banking and housing for revenue.

And how about this - public sector net debt in the UK is £1.27 trillion in March, which amounts to over three quarters of GDP. This is set to peak at almost 79 percent by 2015/16, according to the Office of Budget Responsibility.

This means two things: one, we still have a hell of a lot of debt, compared to other countries – even ones we consider to be in a worse situation than us – and two, chancellor George Osborne is way off target and is likely to continue his austerity policies for some time yet. Hopefully the UK's rising inflation, which is thankfully much nearer target, can ease some of the pain.