Eurozone faces global downturn test

The eurozone enjoyed strong growth during the first half of 2006. But estimates for GDP growth for the third quarter were only 0.5% and experts are divided over the sustainability of recovery.

Investors in the eurozone have had reasons to cheer during the first half of 2006 when equity markets rallied, thanks to strong corporate profitability, ample liquidity and favourable valuations. The Dow Jones Eurostoxx 50 index surged by 4.63% between January 2 and July 3, while the S&P 500 fell by 4.66%.

Over the three months to November 20, the DJ Eurostoxx 50 index rose by 7.81%, in sterling terms. In the year to the same date it grew by 15.92%, while the S&P 500 rose by only 3.43%, according to Standard & Poor’s.

The first half of 2006 was a strong period of growth for the 12-country region, which saw a gradual recovery after a lull in early 2005. The Statistics Pocket Book of the European Central Bank, published in November, shows eurozone GDP was up 2.2% and 2.7% in the first and second quarters of the year respectively, compared with the same quarters last year. On a quarter-on-quarter basis, real GDP growth was also stunning by the zone’s modest standards, at 0.9% during the second quarter.

Yet the flash estimate for the third quarter published on November 14 by Eurostat was only 0.5%, just ahead of America on 0.4%, or 1.6% at an annualised rate, according to the advance estimates released on October 27 by the Bureau of Economic Analysis, the US Department of Commerce.

Despite initial signs of a slowdown, several indicators, such as the Eurozone Purchasing Manager’s index, produced for The Royal Bank of Scotland by NTC Economics, confirm that growth remains above trend, with the October PMI surveys consistent with annual GDP growth in the region of 3%.

The RBS/NTC Eurozone Composite Output index was unchanged at 57.3 in October, indicating a steadying in the rate of increase following three consecutive monthly easings. The survey shows output has risen for 39 consecutive months, while manufacturing saw faster growth than services for the fourth straight month and the increase in new business was at a slightly faster rate than in September.

Nevertheless, the outlook is more uncertain and there is no consensus between the euro-optimists and the doubters as to whether or not the eurozone is running out of steam. The crucial questions are: Can the eurozone and the rest of the world continue to be the engines of global growth as the American economy slows down? And what will be the impact of consolidation of public finances in countries such as Italy and Germany, which are both expected to reduce the budget deficit, where the latter will devote two thirds of the three-point VAT hike scheduled for January to this policy?

Some have started upgrading their GDP growth and interest rate forecasts for 2007. Morgan Stanley, for example, has raised its GDP growth forecast for 2007 from 1.6% to 1.9%, reflecting a more positive view on trend growth in the eurozone, based on cyclical and structural factors.

At the Morgan Stanley Global Economic Forum on November 22, Eric Chaney, the company’s chief economist for Europe, said the VAT rate hike in Germany would have less impact on retail prices than previous ones, while crude oil prices would prove “friendlier to oil importers” than previously thought. He also said the European Central Bank would buy further insurance against inflationary pressures over the course of 2007, although less aggressively than this year.

The Montreal-based BCA Research, a provider of global investment research, echoes the optimism of Morgan Stanley, arguing that the consensus on trend growth for the euro area is too slow, albeit with a more cautious note on European equities. In its European Investment Strategy Weekly Bulletin, published on November 16, BCA Research says it is “time to get very cautious on European equities” because the banking sector – which accounts for 22% of all earnings in the euro area and 20% of the market capitalisation – is over-owned and earnings in both banking and the broader financials sector are running well ahead of overall earnings growth.

Klaus Baader, chief Europe economist at Merrill Lynch, says he does not expect growth in the eurozone to surprise on the upside next year as much as it has in 2006. “We areunlikely to see such massive surprises two years in a row, although we expect the GDP growth to be 2.1% during 2007, a percentage point higher than the median expectations,” he says.

As for the implications of the German VAT hike, Baader says fiscal tightening in the eurozone is unlikely to derail a long and sustained recovery cycle.

Despite a strong historical correlation between the US and the eurozone’s business cycle, the region has a good chance of avoiding the worst effects of a US slowdown next year. This is because the eurozone’s GDP growth, though modest, is being driven by stronger domestic demand, rather than exports. According to the ECB, which assumes the US slowdown will be a soft rather than hard landing, the direct and indirect trade impact on Europe is barely substantial.

Speaking after the ECB meeting in November, Jean-Claude Trichet, president of the ECB, quoted the figure of a 1% slowdown in America transmitting a 0.2% reduction in eurozone growth – taking into account both the direct effect and the echo effect on the rest of the world – and said this was linked to the fact that the eurozone trade with America was less important than was assumed. He added: “The UK is more important for us than the US – to give you an example.”

However, the impact of the American slowdown on European companies is far from neutral as the US accounts for about 17% of the sales of Eurostoxx companies. Philippe d’Arvisenet, chief economist at the Economic Research Department of the Corporate and Investment Banking division of Bank Paribas, says that in light of internal factors and the slowdown in America “it does not look like the strong growth in the eurozone is sustainable beyond the short term”.

Nearly eight years after the birth of the euro, the sustainability of economic recovery in the region is still under question, but it is too soon to conclude that the sceptics will be proved right.