The European Union authorities are encountering potentially severe problems in their relationship wi...
The European Union authorities are encountering potentially severe problems in their relationship with member states as they try to cope with the possibility of deflation, while questions are being asked about banking supervision on a regional and national level.
One of the primary problems is the functioning of the Stability and Growth Pact in severe economic downturns. The primary purpose of the pact ' to prevent the governments of EU member states from overspending, thus destabilising the euro ' is laudable enough, but its inflexibility means governments are being told to spend less when both industry and citizens need support, according to Keith Skeoch, chief investment officer of Standard Life Investments.
France, Germany, Italy and Portugal are close to reaching their 3% deficit limits. Germany has announced E14bn worth of tax increases and spending cuts to cover a predicted hole in next year's budget.
Prospective candidates who wish to join the union have been told to tighten fiscal policy, while France, Germany and Italy have been given two-year extensions to 2006 to try to balance their books.
'The recent admission by EU Commission president Roman Prodi, that the Stability and Growth Pact is 'stupid' has enflamed the debate but could also hasten much-needed reforms,' says Skeoch. 'Pascal Lamy, the EU trade commissioner, has commended the UK's more sophisticated fiscal and monetary framework.'
He defends the European Central Bank (ECB), pointing out it is doing the job it was set by the politicians: controlling inflation across the Eurozone. He states inflationary pressures are being kept high by rigid labour market conditions; the ECB is responding correctly to this by sustaining relatively high interest rates.
Germany is a particularly badly affected by this imbalance: Standard Life calculates that interest rates are set 1% too high for Germany. German inflation is only 1%, so there are concerns deflation could occur if the economy goes into recession. Invesco reinforces the view that Germany has been singled out for economic suffering: the company points out that orders and confidence data have softened yet again, while the supportive effects of foreign orders has now waned.
In contrast, countries like Belgium and Italy have been doing relatively well, especially in terms of business confidence.
Invesco predicts growth across the whole eurozone of 1% (0.5% for Germany), and forsees a low growth environment for 2003.
Rate cuts by the European Central Bank are seen as likely, although they are held back by inflation worries.
Fund manager comment: Aegon
While commentators continue trumpeting the view that equity markets are ~cheap', you have to wonder where exactly have all the buyers gone? Sentiment has hit rock bottom, and while this is usually a positive indicator, markets are in dire need of buyers to give fresh impetus to equities. However, most institutional investors are suffering from distressed financial positions and are having to scale back equity exposure in order to meet liabilities.
European stocks lost more than a quarter of their sterling value during September. In previous months, TMT stocks took the heaviest blows from the stock market slumps. But the de-rating trend has now spread to other sectors, including insurance, investment banking, and acquisitive water utilities.
Defensive stocks such as tobacco, food producers and pharmaceuticals are proving the most resilient, with cash still the safest place for the investor to hide. Telecom stocks, surprisingly, outperformed the broader market in the last quarter, as investors re-appraised their cash-generating aspects.
Firms are under pressure to restructure their balance sheets, which has given rise to more rights issues and a widening of individual credit spreads as investors seek to minimise risks. Europe has seen about $9bn of rights issues since the start of September, compared with $8bn in the first eight months of the year. Debt concern is also inhibiting capital expenditure.
The European markets have displayed tentative signs of a rally in the past couple of weeks, with larger blue chip companies, including Nokia, showing encouraging upward movement. Equities are cheap compared to other asset classes, but earnings estimates still appear slightly too high for this year and next. The forthcoming reporting season remains crucial and a short-term rally looks a possibility, although no one is getting carried away just yet.
Alastair Duffy is investment manager for AEGON Asset Management's European Fund
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