Online Extra: The Eurozone Economy: A Rebound Delayed

The terrorist attacks dealt the region a heavy blow just as recovery appeared imminent. Now, S&P MMS sees an upturn in second-quarter 2002

By Peter Luxton and Timo Klein, S&P MMS

Almost two months after the terrorist attacks in the U.S. and a month into military strikes in Afghanistan, assessments of the events' impact on the European economy are starting to be more than pure guesswork. Forecasts have been revised down, and surveys confirming gloomy expectations have been released. However, S&P MMS believes that a eurozone upturn, of which some signs could be seen before September 11, will reassert itself after the economic shock fades.

The IMF had already become more negative before the September 11 events. Since then, it has cut its eurozone growth projection to 1.6%, from 1.8%, for 2001 and trimmed its 2002 figures to 1.5%, from 2.2%. The Organization for Economic Cooperation & Development's (OECD) leaked preliminary forecasts are even more downbeat, showing a sharp downward gross domestic product revision for the eurozone's major countries. Germany's, in particular, was bumped down from 2.2% to 0.7% for this year and 1% for next year. The German government has slashed its official 2001 forecast from April's 2% to 0.75%. For next year, it expects 1.25% growth, down from a previous forecast of 2.25%. The German chambers of commerce sees almost no growth this year, which implies outright recession going into the end of 2001, given the expansion recorded in the economy during the first part of this year.

CONTINENTAL PALL.

  The increasingly negative tone for Germany underlines starkly the current drift for the eurozone as a whole, where official forecasts are falling in line with the current market consensus of below-average GDP growth -- around 1.5% each for 2001 and 2002. On balance, S&P MMS currently estimates GDP growth across the European Monetary Union at about 1.5% in 2001 and a slightly weaker 1.3% next year. This assumes that a recovery begins to form in the latter part of next year's first quarter.

Predictably, the first EMU surveys on business and expectations conducted wholly in the period after September 11 -- the Reuters manufacturing and survey indexes (data collected Sept. 22-28) -- posted large month-on-month declines. This was followed by the September German IFO business climate survey, which is taken as a key early indication of likely sentiment across the eurozone, even though it's centred on German manufacturers' expectations. The poll showed the steepest monthly fall since the oil-price shocks in the early '70s and is back at levels seen when Germany was last in recession in 1993. Orders in manufacturing tumbled precipitously as companies simply put a halt to any commitments as long as uncertainty was so high.

Subsequent manufacturing and consumer sentiment indexes from other EU countries, such as Italian and Belgian business confidence and Netherlands consumer sentiment, showed a similar tone. The gloom was reinforced by Britain's "disastrous" October Confederation of British Industry quarterly industrial-trends survey, while the October EMU-wide purchasing manager's index that was released later recorded series lows.

Many of these sentiment surveys concentrate on manufacturing, but the tone from the service side of the economy is little better. The service component of the EMU indexes slipped below the zero-growth level of 50 for the first time in the data's three-year history in September. The poor showing has to do with the extreme pessimism now prevalent for travel-related sectors, especially air travel and including restaurants and hotels. This mirrors developments in the U.S., and although there isn't a one-to-one link, the terrorist attacks, exacerbated by heightened global tension, chill global demand and, thus, hurt eurozone jobs.

FACING RECESSION DOWN.

  The latest economic evidence from just before the attacks showed that eurozone activity was probably bottoming during the summer. Noteworthy were the German orders and production increases in August, together with the July and August IFO survey's climbing expectations indexes. In addition, the improving economic expectations of the 300 German financial experts polled for the July-to-September ZEW reports -- even though 56% of Sept. answers were after the attacks -- and the still-healthy 7% increase year-on-year for September German car output suggested a trough occuring.

Hence, the attacks hit at a critical time for the eurozone business cycle. The September 11 events are thus likely to have postponed recovery and furthered the drop in economic activity, but business-cycle forces will come to the fore again after a delay. Hence, our view is that the eurozone will pick itself up off the floor from the second quarter of next year. The region looks recession in the white of the eyes but faces it down.

Against this background, we don't see deflation emerging as a danger in the eurozone, not even in Germany. Headline consumer prices are likely to rise by an average of about 2.6% this year and around 1.7% in 2002. Some time next year, price increases may briefly dip to a low point -- below 1.5% in the second quarter because of the hefty food price gains earlier this year dropping out of the calculation. However, short of a euro surge above parity against the U.S. dollar or a full-blown recession, neither of which S&P MMS expects, there's no reason to suspect that year-on-year inflation rates can move below 1% next year. The European Central Bank has lots of things to worry about these days, but unlike the Bank of Japan, deflation isn't one of them.

Luxton is S&P MMS' global economic adviser, and Klein is chief European economist.

Standard & Poor's MMS real time analysis of the global fixed income, forex and emerging markets is available on the Web at www.GLOBALMARKETS.COM

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