The Fallout in Europe

America's deepening woes are spreading across the Atlantic

It may be a measure of the times that sticking to a business plan can seem like an act of patriotism. You can almost hear a stirring march as Ryanair (RYAAY ), the Irish budget airline, charges ahead with plans to acquire eight new planes by March, while negotiating the purchase of 50 more. "People are still traveling," says CEO Michael O'Leary, who, in contrast to other airline chiefs, reports no drop in bookings.

Brave words. But can stubborn optimism protect Europe from the economic and political turmoil that has followed the Sept. 11 terrorist attack? Not likely. Just look at what happened in one short week. British Airways is cutting 7,000 jobs, one-eighth of its staff. Volkswagen (VLKAY ) scheduled week-long shutdowns at its two main factories in Germany. Designers even canceled all parties at the fall fashion shows in Milan.

Europe's economy was slowing even before the assault on the U.S. Now it could be heading into recession. Germany is likely to be hardest hit, since it has the biggest exposure to the U.S. Earnings at German auto maker DaimlerChrysler (DCX ), for example, are expected to fall more than 70% this year, thanks to slumping sales at its Chrysler Group unit. "For the first time, all the European economies are moving in the same, negative direction. This quarter and the next quarter will not be good ones," says Klaus Zumwinkel, CEO of Deutsche Post World Net.

For most of the year, many European leaders and economists argued that Europe would weather the storm that has pummeled the U.S. and Asia, since foreign trade accounts for less than 20% of the euro zone's economy. Besides, they thought, tax cuts in Germany, France, and Italy would drive domestic demand forward. Following the attacks, however, economists have halved their forecast for euro-zone gross domestic product growth in 2002, to 1.1%. UBS Warburg now expects zero growth in the third quarter of 2000 and -0.2% in the fourth quarter--for all intents and purposes a recession. Many investors are even more pessimistic. "Nobody really believes earnings forecasts or valuation numbers," says George Hodgson, European equity strategist at London's ABN Amro Holding.

LINKED FATES. There's a lesson here about the flip side of globalization. As America's economy took off in the 1990s, Europe's multinationals wanted to cash in on the boom. So companies from Alcatel (ALA ) to Vivendi (V ) to Deutsche Bank snapped up U.S. companies. The result: Businesses such as Munich-based Siemens rely on U.S. operations for nearly 25% of sales. Now, U.S. sales of Siemens products such as auto parts and lighting are suffering. So if the U.S. sinks into a recession, the damage for the Europeans will increase.

Since Sept. 11, companies have begun canceling or delaying investments, cutting workforces, or scrambling for capital. The wave of bad news is sure to hit household spending. "The consumer was already in a fragile situation, so this looks very dangerous," says Lorenzo Codogno, head of euro-zone economics at Bank of America (BAC ) in London. The tension is heightened by the upcoming introduction, on Jan. 1, of euro notes and coins. It's not exactly the perfect moment to ask Europeans to give up their familiar deutsche marks, francs, and lira.

The glum mood has sharply diminished the appetite for risk. In Berkshire, England, backers of a telecom startup called Artaurus suddenly withdrew a promised $4.3 million in first-round funding. Initial public offerings, already at a trickle, will take that much longer to recover. European Aeronautic Defense & Space Co. (EADS), the maker of Airbus planes, canceled plans to boost production capacity. Says Co-Chief Executive Officer Philippe Camus: "Frankly speaking, nobody knows exactly what will happen."

At least falling inflation gives the European Central Bank leeway to cut interest rates. Some analysts predict a cut of as much as 150 basis points, to 2.25%. Such cuts could relieve the pressure on Europe's indebted telecom companies by lowering the cost of capital. A cut of 150 basis points in the next year would add $420 million to France Telecom's bottom line, according to a study by Dresdner Kleinwort Wasserstein.

AUSTERITY PLAN. Yet rate cuts probably won't be accompanied by big government spending. Policymakers don't want to stray too far from the fiscal prudence they adopted when creating a common currency. At a dinner with German executives on Sept. 24, Chancellor Gerhard Schroder rejected suggestions that the government speed up tax cuts or subsidize ailing industries such as airlines, according to several participants.

The coming pain won't be spread evenly. The obvious victims are airlines, aircraft makers, and their suppliers. Makers of luxury goods are nervous, too. "It is too early to know what the consequences might be in terms of sales," says Francesco Trapani, CEO of luxury jeweler Bulgari. Investors seem to have made up their minds: Bulgari shares have plunged more than 30% since the bombings.

Who will escape? Chiefly companies that make things people can't do without, such as pharmaceuticals and food. Banks, too, could emerge relatively unscathed. "People will continue to need banking services," says Keith R. Whitson, CEO of HSBC Holdings PLC in London. Some high-tech companies may profit if they offer cost-cutting tools. "In Europe, we grew our business 10% last quarter. I remain confident," says Sergio Giacoletto, executive vice-president for Europe, the Middle East, and Asia at software maker Oracle Corp. (ORCL ).

A sharper-than-expected downturn will offer opportunities for predators. Frankfurt-based MG Technologies, the engineering and chemicals business, is trading below book value. After a 60% share-price decline this year, the once-mighty conglomerate has a market capitalization of less than $1 billion--an invitation to corporate raiders. Already under attack is FAG Kugelfischer, a maker of ball bearings. In a hostile bid, rival INA Holding has offered FAG shareholders a 50% premium on the company's battered shares. As slumping stock markets create bargains, the trend is likely to accelerate. "We are looking for opportunities," says Deutsche Post's Zumwinkel, who has already bought dozens of smaller distribution and freight companies. "Asset prices worldwide are down, and I mean ridiculously down."

Share prices could slump even more when the shooting starts. "Everyone is waiting to see what's going to happen in Afghanistan," says Mario Maselli, president of Emmetex, a textile maker that employs 400 people in Prato, Italy. For now, Maselli has put on ice plans to expand capacity by 15%. Unfortunately, that's just the kind of microeconomic decision that, repeated a thousand times, spells a nasty downturn.

By Jack Ewing in Frankfurt, with David Fairlamb in Liege, Kerry Capell in London, and bureau reports

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