While the future looks bleak for European economies in the wake of the 11 September terrorist attacks, the continent is unlikely to go into recession
Is Europe facing a recession in 2002? The short answer is no, but it will feel like one.
The backdrop is not encouraging ' the world economy has been slowing ever since early 2000, with growth slipping from an unsustainable 5.2% annualised in the first quarter of 2000 to just 0.2% in the second quarter of 2001. Europe has charted the same path, with growth fading from 4% to 0.2%.
Even so, there had been signs that the long slowdown was ending. Closely watched indicators of future economic activity, such as the OECD lead indicator for the world and the IFO industrial survey for Germany (and by extension Europe) began to gain ground during the second quarter of 2001, suggesting an upturn during the fourth quarter.
To reinforce this notion some real economy data, such as industrial production, was improving by August. But the events of 11 September put a stop to such optimism.
Prior to September, much of the slowdown had consisted of industrial companies cutting back on investment spending and then running down inventories that had been built up in the expectation that growth would continue to be super-strong. Consumer demand had remained reasonably buoyant but surveys were suggesting unease about the future.
In the aftermath of the terrorist attacks on the US, these fears were heightened. In addition, a swathe of companies announced reduced earnings expectations and plans for cost savings including redundancies. In such circumstances, it would be unrealistic to expect strong consumer spending. Surveys of companies' outlooks and spending intentions ' the so-called purchasing manager surveys ' showed huge falls, suggesting a sharp slowdown in activity. As a result, the economies of Japan (already weak as a result of its continuing banking crisis) and the US (where previous growth had been particularly strong and financial imbalances particularly severe) are now assumed to have moved into recession.
Most observers believe they are unlikely to recover until the second quarter of 2002 at the earliest. The weakness of two such economic powerhouses will probably push the whole world into recession.
But if this is the case, then why not Europe as well? It is partly a matter of maths. Europe did not see the same scale of growth during the boom as the US and consequently has less far to fall. Furthermore, the high technology industries that were the darlings of the boom and the biggest losers of the slump represent a much lower proportion of the European economy than they do of the US and therefore exert a smaller influence on the numbers.
Another important issue is that of financial condition. European consumers have nothing like the levels of debt of their US counterparts, so their spending patterns have less of a correlation with economic cycles.
On the business side of the equation, the financial system is quite strong. In the main, banks are profitable, reducing the risk of a credit crunch and offering financing for the projects that will re-ignite growth. This is why Europe is so different from Japan: there, the banks are so weak that they are unable to lend, even though this is crucial to re-starting the economy.
Policy is a more problematic area. The European Central Bank has received heavy criticism for its inertia in the face of the slowdown, being compared very unfavourably with the US Federal Reserve. Similarly, it is argued that in fiscal policy, the Maastricht Stability Pact places a straitjacket on European finances ' in stark contrast to the massive fiscal stimulation under way in the US. Such criticisms are valid and poor communication by the ECB has certainly done nothing for confidence.
However, the negativity should not be pushed too far. On the monetary side, Europe has not reduced interest rates as much as the US, only 1% compared with 4% on the other side of the Atlantic. That said, at the beginning of 2001 European rates were already 1.75% below those in the US, and additional cuts by the ECB, perhaps by as much as another 1%, are in the pipeline.
On the fiscal side, while the Stability Pact is a problem, it should not be forgotten that substantial fiscal packages were introduced in Germany, France and Italy in 2000. All these will influence their respective economies during this year and the next. In addition, the generous nature of European social security systems means that, in the absence of official action, fiscal policy automatically loosens during a downturn. As an extra kicker, the timing of the switch to euro notes and coins early in 2002 will provide some boost to demand as undeclared income held in currency is spent rather than exchanged through the banking system.
This is not to say that everything in the garden is lovely. European GDP growth may not turn negative, but it will be very slow. Individual countries will be affected differently. Germany, which has a relatively high exposure to world markets, is a racing certainty for recession and Italy, whose poor fiscal situation restricts policy responses, may well follow. On the other hand, France, Spain, the Netherlands and the UK, although slowing, should remain in reasonable shape.
Overall, we are likely to see annualised growth rates of less than 1% for two or three quarters, and European industrial production is likely to decline. Unemployment will rise substantially. However, the policy response is already in place in the form of low and falling interest rates, substantial money creation and fiscal stimulus, and the transmission mechanism for the stimulus ' the banking system ' is strong. It would therefore be surprising if there was not a recovery starting some time in 2002.
In such an environment, what should investors do? The decision on bonds against equities looks to be weighted heavily towards equities as, even after recent rallies in equities and allowing for falls in earnings, shares look inexpensive. Within equities, the decision is more complex. Defensive areas such as consumer staples, pharmaceuticals and utilities have performed well during 2001 as investors have sought the security of their predictable earnings. As a group, however, they are very expensive relative to the rest of the market, and more expensive than they have been at similar times in other economic cycles. Their moment looks to be past ' unless some new negative event occurs.
Cyclicals, both traditional and high technology, look more interesting. Construction-related stocks benefit directly from low interest rates and government pump priming. They have performed well already but still look to have some value. Other cyclicals are more problematic, as analysts' forecasts still look implausibly high. An adjustment to more realistic figures could have a severe impact on their share prices, and this suggests caution is appropriate.
The third-quarter results season should clarify the situation and may suggest that a position in the cyclicals should be built in the last couple of months of the year. Consumer cyclicals look as if they offer more security than industrials ' given the impact of a fall-off of US demand for the latter group. Technology stocks do not, as a group, offer great value but they do tend to be driven by sentiment. In the context of a market rally, they should perform well.
Oil stocks present a conundrum. The oil price is weak and so is the economy, so there is no reason for the stocks to perform. Against that, oils are the classic investment hedges against something awful happening in the world, and that, depressingly, is a real possibility.
Finally, what about financials? They perform well in a low interest rate environment, but they particularly prefer falling bond yields and these may have bottomed. Banks like steep yield curves because they can make easy money by borrowing short and lending long, but they do not like economic slowdowns because they are affected by bad debts, and these bad debts tend to rise after the economic cycle turns. Furthermore, it seems unlikely for now that retail investors will be tempted back into higher risk, and (for the banks) more profitable investments. Consequently, commission income is likely to remain depressed.
Overall, financials appear to be a risky place to be over-invested, with one possible exception ' composite insurers and reinsurers, where the recent disasters should lead to a substantial increase in premiums.
To summarise, a European recession is unlikely, although we will go pretty close to one. On that basis, the optimum portfolio should contain a solid weighting in cyclical and economically sensitive stocks, a low weighting in defensive and interest sensitive names, a neutral position in oil stocks and probably a lower-than-market-weighting in financials. Equities are to be preferred over bonds and cash.
The world economy has been slowing ever since early 2000.
The events of 11 September put a stop to signs that the slowdown was coming to an end.
Europe did not see the same scale of growth as the US during the boom and has less far to fall.
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