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Shock absorbers

In recent weeks, analysts have been revising and re-revising down their outlooks for the eurozone economy along with global forecasts as a slew of bad news shocks have been digested by the market. This is a very different situation to that of six months ago and is in contrast to the region’s business cycle over the last two years, which has been trending upward.

It is, however, by no means game over. If the US can avoid recession, the European Central Bank can hold firm and the current financial shocks can be absorbed, then the region’s positive fundamentals should once again come to the fore and support economic growth, even if at a lower level.

Admittedly, there are a lot of ifs and what is almost certain is that short-term growth will weaken.

The ECB finds itself in a particularly difficult position. The Fed has cut interest rates to 4.25 per cent and is likely to cut again and the Bank of England is expec-ted to reduce rates soon from the current level of 5.5 per cent but the ECB has less room to manoeuvre due to stubborn inflation risks. Inflation for the region ran at 3.1 per cent in December and core inflation at 2.3 per cent, above the central bank’s target of about 2 per cent.

The combination of energy and food price rises, high resource utilisation rates and a sluggish supply side means that demand will need to become substantially more lacklustre to reduce the upside risks to inflation and bring utilisation rates back to equilibrium. Interest rates in the euro area may therefore remain on hold for longer than in the UK and US.

To compound the risks to economic growth, additional pressures from the repricing of risk in credit markets and funding difficulties have already caused retail banks to raise their borrowing rates, which could dent income both for households and corporates who have floating rate mortgages or loans and reduce corporate plans for investment and expansion.

The ECB’s January bank lending survey showed that bank lending standards continued to tighten in the three months to January. However, while corporates are net borrowers, in the eurozone, the majority of households are net savers. Therefore, increases in savings rates should partly offset the effect of higher borrowing rates on household incomes.

The euro has appreciated substantially over several months against the US dollar (and sterling), which could be a double-edged sword.

On the one hand, it is worrying for exporters, likely to squeeze corporate profits and dampen growth. The exact mechanics of this will depend on how exporters price their products. If they price in euro, they will become uncompetitive. If they price in local market currencies, their profits will suffer. Either way, it is unlikely that they welcome a strengthening in their currency.

In addition, a fall in exporters’ profits would eventually feed through to the labour market and capital investment.

On the other hand, the stronger euro could help to ease inflationary pressures in the economy as imports become cheaper, providing the ECB with more scope to ease interest rates.

Although Europe is not immune to the global headwinds described above, there are some positive beacons in the mist which make the region still attractive for long-term investors. Many high-quality European stocks already represent good value on a price-to-earnings basis, particularly compared with Japanese and US stockmarkets.

The outlook is uncertain at the moment because it is so difficult to predict how long it will take for the financial shocks to be absorbed by the economy.

If the US falls into recession, it would have a negative impact on the eurozone’s economy due to exchange rates, trade linkages and asset prices. But if the US can skirt past a recession, the outlook is promising.

Provided the ECB can steer a steady course, avoiding the pitfalls of high inflation or sharply decelerating growth, the positive fundamentals exhibited by the economy over the past two years should reassert themselves once the financial shocks have been absorbed.

Jon Ingram is co-manager of the JP Morgan Europe dynamic ex UK fund


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