European Economic Recession Ahead? 1

By Jean-Michel Six, Standard & Poor's
From Standard & Poor's Equity Research

Results for the first quarter of 2008 could have made us believe that Europe would remain relatively immune from the U.S. slowdown and the disruptions in financial markets. Since then, however, a flurry of data from across the region consistently suggests that such views were overly optimistic, and a major slowdown is about to occur in the second half of this year.

Gross domestic product (GDP) in the Eurozone contracted at a 0.8% annual rate in the second quarter. Additionally, the July survey of purchasing managers in manufacturing and services dropped to its lowest level since 2001.

Meanwhile, consumer price inflation in the Eurozone accelerated to 4.1% in the 12 months to July, its highest level since the introduction of the single currency in 1999. Inflation also accelerated in the United Kingdom to 4.4% year-on-year (3.8% in June). We consider the outlook for inflation in the next 12 months to be the most critical variable for Europe’s economies. Indeed, we think a deceleration on the back of lower oil prices would create a very different environment for monetary policies and provide a relief for hard-squeezed consumers. Until then, however, Europe should brace itself for a period of stagflation.
Economic storm gains strength

Economic reports published recently painted a bleak picture. The data are indicative that European economies are currently in the middle of a storm. Its components include:

A downturn in world trade induced by the weakening U.S. economy and whose effects are compounded by the strong euro exchange rate; the unwinding of the housing bubbles in key economies such as the United Kingdom, Spain, and Ireland, now extending to other countries such as France, Denmark, and Portugal; and accelerating retail price inflation on the back of surging commodity prices. This curtails consumers’ purchasing power and prevents central banks from adopting more supportive policies, while lenders clamp down on credit growth as wholesale funding dried up.

In the face of this slew of negative data, business and consumer sentiment is heading south. In July, the Eurozone purchasing managers index (PMI) tumbled to its lowest level in the 10-year history of the series (except for October-November 2001). The PMI decline was mirrored in the national business surveys. The August Ifo business confidence survey for Germany showed a marked decline in business leaders’ expectations of future conditions, comparable to what was seen in early 2004, when the German economy began to slow. The July ZEW indicator of economic sentiment, which focuses more on investors’ expectations in that same country, showed a similar deterioration.

Consumer surveys are similarly bleak, reporting a sharp deterioration on the back of worsening conditions in labor markets, as weak domestic demand and margin compression lead companies to curtail hiring. The biggest drop in confidence took place in Spain in June, which is hardly surprising given the fast deceleration in economic growth taking place at the moment in that country, although French sentiment also plummeted to levels not seen since early 2005 when Europe as a whole was experiencing anemic growth.

In the United Kingdom, the number of benefit claimants rose by 15,500 in June, the highest single-month increase since December 1992, highlighting a weakening labor market.

European car sales contracted by 7.9% in the month of June, according to ACEA, the European Association of Car Manufacturers. The breakdown of the ACEA numbers shows, however, that the economic slowdown is uneven across the region: In France (+1.5%) and Germany (+1.0%), the number of registrations increased, while the markets in the United Kingdom (-6.1%), Italy (-19.5%), and Spain (-30.8%) deteriorated.

All these negative signals point to the same question: Is the European economy about to enter into a period of recession, with several consecutive quarters of negative growth?

The strong euro is weighing on the performance of Eurozone exports.