Results for the first quarter of 2008 could have made us believe that Europe would remain relatively immune from the U.S. slowdown and the disruptions in financial markets. Since then, however, a flurry of data from across the region consistently suggests that such views were overly optimistic, and a major slowdown is about to occur in the second half of this year.
Gross domestic product (GDP) in the Eurozone contracted at a 0.8% annual rate in the second quarter. Additionally, the July survey of purchasing managers in manufacturing and services dropped to its lowest level since 2001.
Meanwhile, consumer price inflation in the Eurozone accelerated to 4.1% in the 12 months to July, its highest level since the introduction of the single currency in 1999. Inflation also accelerated in the United Kingdom to 4.4% year-on-year (3.8% in June). We consider the outlook for inflation in the next 12 months to be the most critical variable for Europe’s economies. Indeed, we think a deceleration on the back of lower oil prices would create a very different environment for monetary policies and provide a relief for hard-squeezed consumers. Until then, however, Europe should brace itself for a period of stagflation.
Economic storm gains strength
Economic reports published recently painted a bleak picture. The data are indicative that European economies are currently in the middle of a storm. Its components include:
A downturn in world trade induced by the weakening U.S. economy and whose effects are compounded by the strong euro exchange rate; the unwinding of the housing bubbles in key economies such as the United Kingdom, Spain, and Ireland, now extending to other countries such as France, Denmark, and Portugal; and accelerating retail price inflation on the back of surging commodity prices. This curtails consumers’ purchasing power and prevents central banks from adopting more supportive policies, while lenders clamp down on credit growth as wholesale funding dried up.
In the face of this slew of negative data, business and consumer sentiment is heading south. In July, the Eurozone purchasing managers index (PMI) tumbled to its lowest level in the 10-year history of the series (except for October-November 2001). The PMI decline was mirrored in the national business surveys. The August Ifo business confidence survey for Germany showed a marked decline in business leaders’ expectations of future conditions, comparable to what was seen in early 2004, when the German economy began to slow. The July ZEW indicator of economic sentiment, which focuses more on investors’ expectations in that same country, showed a similar deterioration.
Consumer surveys are similarly bleak, reporting a sharp deterioration on the back of worsening conditions in labor markets, as weak domestic demand and margin compression lead companies to curtail hiring. The biggest drop in confidence took place in Spain in June, which is hardly surprising given the fast deceleration in economic growth taking place at the moment in that country, although French sentiment also plummeted to levels not seen since early 2005 when Europe as a whole was experiencing anemic growth.
In the United Kingdom, the number of benefit claimants rose by 15,500 in June, the highest single-month increase since December 1992, highlighting a weakening labor market.
European car sales contracted by 7.9% in the month of June, according to ACEA, the European Association of Car Manufacturers. The breakdown of the ACEA numbers shows, however, that the economic slowdown is uneven across the region: In France (+1.5%) and Germany (+1.0%), the number of registrations increased, while the markets in the United Kingdom (-6.1%), Italy (-19.5%), and Spain (-30.8%) deteriorated.
All these negative signals point to the same question: Is the European economy about to enter into a period of recession, with several consecutive quarters of negative growth?
The strong euro is weighing on the performance of Eurozone exports.
On a trade-weighted basis, the exchange rate of the euro against the zone’s major trading partners strengthened since the beginning of 2007 to reach its highest level since 1999 in April 2008. At a time when foreign demand for Eurozone products, particularly from the United States but also from the weakening United Kingdom economy, is sliding, a strong currency is an obvious impediment.
That said, more positive factors should also be considered. One is that Eurozone exporters have benefited significantly from the rising import demand from oil-exporting countries. Export revenues of major oil-exporting countries rose to $1.3 trillion in 2007 from about $412 billion in 2002, on the back of the sustained rise in oil prices.
A study in the July 2008 issue of the European Central Bank’s (ECB) monthly bulletin showed that despite the growing share of Asian exports in these markets, Eurozone exporters have been able to maintain a high and stable market share in recent years, averaging 25% in 2007. This positive outcome must be nuanced, however, as it has been driven mainly by Russia, as Eurozone exports’ market share in other oil-exporting countries (mainly OPEC) declined slightly to 21% in 2007 from 25% in 2002.
But over that same period, the U.S. market share in total imports of oil-exporting countries (Russia included) decreased to 7.5% from 12.0%. In other words, Eurozone exporters were able to maintain or even increase (in Russia) their market share despite the handicap of a strong currency. Between 2002 and 2007 the annual growth in export volumes of goods to OPEC and Russia was on average 7% and 17%, respectively, significantly above the average growth in extra-Eurozone exports of around 5%. Strong demand from those economies will continue to boost Eurozone exports in 2008 and 2009.
The second mitigating factor comes from the outlook for the euro exchange rate itself. Our baseline forecast expects the euro exchange rate to peak against the U.S. dollar in the third quarter of 2008 near 1.60. Then, the rate should slowly decline, as the fundamentals begin to turn in favor of the U.S. currency, with weaker growth prospects in the Eurozone and an increased probability of an interest rate hike in 2009 in the United States. We expect the euro to retreat toward 1.45 in the fourth quarter of 2008 and to 1.40 by mid-2009.
Overall, Eurozone export growth should drop to 4% in 2008 (6% in 2007) and 3% in 2009. German exports are likely to follow a similar trend, rising 4.7% in 2008 (8.0% last year) and 3.0% in 2009. French exports, after an upbeat performance in the first quarter of this year, should experience a very modest rise in the second half of the year, leading to an average increase in 2008 of 3.9% (3.6% in 2007). French export growth in 2009 is likely to ease further to 3.0%.
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