Eurozone upturn is gathering pace

Despite the recent political problems in France and Italy, prospects for the eurozone remain good, with the German recovery riving growth and unemployment falling across the region.

The past few weeks have not been kind to the eurozone. Following weeks of mass protests, Dominique de Villepin, the French prime minister, withdrew the proposed youth labour law (the CPE) that would have allowed employers to fire employees under the age of 26 within the first two years of their employment. Although only modest, the CPE was at least a step towards unshackling France’s notoriously inflexible jobs market and helping to bring down the country’s 9.1% unemployment rate, the second-highest in the eurozone. Following such an about face, the French government is unlikely to push through any other unpopular reforms.

Italy, too, has been thrown into political turmoil, although the country’s main hurdle is not so much high unemployment as its growing lack of competitiveness. In the past, Italian policymakers could restore competitiveness through successive devaluations of the lira, but that is no longer an option now that Italy has adopted the euro.

Moreover, the country’s unstable political system – Italy has had nine prime ministers in the past 15 years – has stymied much-needed economic reform. Changes to the electoral process were meant to give the government a firmer foundation to push through unpopular policies. But prime minister elect Romano Prodi’s wafer-thin majority suggests that his position is not much less precarious than his predecessors’, dashing any hopes of meaningful reform.

To compound the eurozone’s troubles, sentiment has begun to deteriorate towards the region’s economic upturn, and economists, on average, have started to downgrade their forecasts for growth this year. Although the consensus forecast is for the eurozone to grow 2% this year – its fastest rate since 2000 – that is still a little slower than the average growth rate it managed during the 1990s, and growth is forecast to cool again next year.

As a result, European stockmarkets, which have climbed almost 40% over the past 18 months, have stumbled, as investors have begun to question the sustainability of the recovery. The main worry for investors is that activity has failed to match the surge in business confidence in recent months, with consumer spending remaining sluggish.

Moreover, the recovery has been largely confined to Germany – German manufacturing orders are their strongest in 20 years. Meanwhile, activity in France and Italy, the eurozone’s second and third-largest economies respectively, has remained more subdued.

However, there is mounting evidence that the recovery is spilling over from German manufacturers and that the upturn is gathering momentum. Construction orders across the region are their most buoyant since German reunification, and activity in France and Italy is beginning to catch up with the German upswing.

Wage growth may have remained sluggish as firms have sought to fight down costs in order to boost their competitiveness, but unemployment across the region has fallen from almost 9% 18 months ago to its current rate of 8.2%. With business surveys suggesting employers are even keener to expand their workforces in the months ahead, and consumer confidence beginning to climb, the strength of consumer spending could easily surprise the markets.

Despite the encouraging outlook, there are still somerisks. One danger is a policy mistake, such as the European Central Bank raising interest rates too enthusiastically. Nevertheless, the ECB has sought to calm expectations of sharp rises in interest rates over the remainder of the year, showing that it is well aware of the risks of tightening policy too quickly.

Another policy risk is the impending 3% rise in German VAT, due in January. Japanese policymakers made the same mistake in the mid-1990s in an attempt to take advantage of the country’s

apparent upturn and patch up the public finances, and it took several years for Japan to recover from the resulting slump in consumer spending.

Another threat to the eurozone’s nascent recovery would be a sharp appreciation of the euro, and the likely impact on exports. With European interest rates rising and activity accelerating, the euro is once again becoming attractive to international investors. Nevertheless, American money market rates at 5.25% still offer investors a substantial premium over rates in Europe and Japan, and the euro is unlikely to strengthen significantly for some time to come.

While there are risks, the economic climate remains promising, and the outlook for profits more upbeat still. Although profit growth has cooled from its initial surge as the eurozone climbed out of recession, profits are still growing at an annual rate of about 30% a year. The improving economic climate should help profits growth accelerate again and investment analysts are their most upbeat on the outlook for profits for more than 17 years. Although economic reform remains off European politicians’ agendas, growth is set to confound the sceptics, and there is still more to come from European stockmarkets.