So Much For The Recovery

Only a few months ago, economists were scrambling to hike growth forecasts as surging exports vaulted Europe out of its worst recession in decades. Now, the number crunchers are at it again--but in reverse.

As the mighty German mark weighs down Europe's hard-currency core, economies across the region are beginning to come back to earth. With Japan in the doldrums and the U.S. economy starting to cool, Europeans are waking up to the realization that they're about to be caught in the middle of a global growth slowdown. For the large number of European economies still burdened with high debt and too much slack, "this landing," admits Salomon Brothers Inc. London economist Kermit L. Schoenholtz, "is coming far earlier than we would have hoped."

Over the past few weeks, long-term European interest rates have fallen as expectations of a slowdown have spread (chart). Even with the dollar rebounding a bit against the mark and other currencies, the European Union predicts the recovery that began last year will peak with 3.1% gross domestic product growth in 1995 and slip to 2.9% in '96. At that rate, the EU will be lucky to keep unemployment at 10%. By 1997, figures Smith Barney Inc. Paris economist J. Paul Horne, EU growth may be down to 1.2%.

Long before then, the slowdown is likely to provide fertile ground for a revival of political and market turmoil in an EU whose members are already burdened by excessive debts, expensive social programs, and misaligned currencies. Considering that Europe has had a tough enough time dealing with these liabilities when growth is solid, crafting spending cuts and fiscal restraints will be even harder--and less popular than ever--as the recovery wanes.

GRILLED FRANC. France is one key country facing such a squeeze. Efforts to maintain a robust franc whose value moves in lockstep with the mark have cost French manufacturers dearly as they try to compete against producers in Spain, Italy, and Sweden, where currency devaluations have boosted exports. Worse yet, to maintain its link with the mark in the face of high government deficits, France has also had to eep short-term interest rates at a painfully high 7.1%--2.5 points over those in Germany. High unemployment may prompt new President Jacques Chirac to press for lower rates to keep his campaign promise to boost jobs. If he does, a renewed attack on the franc could send interest rates shooting even higher.

Further rate cuts by the Bundesbank, of course, could allow France to follow suit without sparking a currency crisis. Deutsche Bank CEO Hilmar Kopper says Germans will be fortunate if growth in Europe's largest economy reaches last year's level of 2.3%. The generous recent wage increases and the strong mark, he adds, signal that "prospects for exports, investment, and the job market have all dimmed."

SUNSET PROFIT. Executives in Germany and beyond now find themselves looking back at impressive profit numbers--and ahead toward uncertainty. Take auto and aerospace giant Daimler Benz. Its sales for the first four months of 1995 were only 2% over '94 levels, a sharp slowdown from gains it had been recording earlier in the year. Italian auto maker Fiat, meanwhile, has been feasting off the competitive advantage of a cheap lira to boost exports to its neighbors in the German mark zone. But Fiat's pickings have been slimmer at home. The Italian government's efforts to rein in public spending and reform pensions has dampened consumer confidence. Fiat's April domestic sales were down 1.6% compared with a year earlier.

Similarly, Peugeot boss Jacques Calvet worries that "we have without doubt overestimated the vigor of markets." He thinks European car sales will grow just 1.9% this year and is lobbying the Chirac government to extend a rebate program for new-car purchases that expires in June.

But European consumers may not be in a buying mood. British retailer Marks & Spencer PLC, for example, recently reported a record $1.4 billion profit for 1994 but saw its stock hammered by traders hoping for more. One problem: Operating earnings from stores on the Continent tumbled 26%. "Consumers are fairly grim," concedes Derek Hayes, Marks & Spencer executive director for continental Europe.

As economic activity weakens, inflation is expected to decline in Germany. Not so, however, in Britain. The Bank of England now may be obliged to raise rates even in the face of flattening industrial production and retail sales. Price pressures are also surfacing in Italy, where economists at James Capel & Co. estimate the lira's sharp fall will help push inflation to 5.6% this year and 6% in '96. Indeed, rising labor costs and sluggish consumer spending are putting Italian entrepreneurs on the defensive. "We cannot afford to make mistakes at this stage," says Giuseppe Lavazza, marketing director of Turin-based coffee producer Luigi Lavazza. "We're being very cautious."

As slower EU growth unfolds, caution is likely to be the buzzword of 1995. Europe's recovery has been short and sweet. Next comes the bitter aftertaste.

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