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Europe’s Long March Sideways By Scott B. MacDonald NEW YORK (KWR) December 4, 2005 -- The European Central Bank (ECB) has announced its “accommodative” stance on interest rates is coming to an end and rates will be going up. ECB President Jean-Claude Trichet was careful to emphasize that such a shift in policy did not mean the start of a “series” of interest rate hikes, only a “moderate augmentation.” The reason for the change in direction is pressure from higher energy prices, a few signs that capital spending is picking up, and hope that some upcoming reports may show rising confidence among French and Italian businesses. Clearly, the ECB wants to make a pre-emptive strike on inflation. Almost as an aside, Trichet also admits the economic outlook is “subject to downside risks”. Indeed. Two things can be taken from the ECB’s change of direction – Europe is continuing its great sideways momentum on the economic front -- though in the worst case it could be heading closer to a recession -- and the Euro will remain weak vis-à-vis the U.S. dollar. It has already declined 13% thus far in 2005. Europe’s economic performance has been anemic over the last several years, substantial structural problems remain and social discontent is growing as reflected by the recent round of riots in France’s inner cities. Take the German economy. While there has been a restructuring of many large German businesses and exports are strong, the domestic economy is troubled. Q3, 2005 numbers gave real GDP growth year-on-year at 0.6% (the highest in four years) - to a backdrop of 0.1% domestic demand, a decrease in private consumption, and unemployment of 11.6%. As High Frequency Economics commented of Q3 economic data: “People say Germany’s economy is recovering. We say that we see no sign of it in these data. Were it not for strong sales, the economy would be in a depression.”
Source: Aladdin Capital Research Prospects for the French and Italian economies are not much better. France is struggling to maintain a pace of real GDP growth above 1% and Italy is seeking to escape a recession. The problems are very similar to Germany – high unemployment, rigid labor markets, and political resistance to change. It is the last that probably puts Europe on track for sideways economic growth at best – and recession by 2007 at worst. Germany’s first woman chancellor, Angela Merkel, took office in November at the head of grand coalition that many pundits believe is doomed to failure because of the very different views of coalition members. Indeed, even before she assumed office, her government was under attack by central bankers and economists arguing that it must do more to spur growth and employment. At the same, the German government has scheduled a tax increase for 2006, a measure that is not exactly in sync with spurring economic growth. In Italy, it appears likely that the center-left will return to power in the April 2006 parliamentary elections, while most of the French political elite is in an anti-globalization and anti-reform mood and more focused on who will follow Jacques Chirac as president in 2007. None of this bodes well for finding solutions to high unemployment and social angst. Consequently, we have deep concerns about Europe’s economic direction, especially as Germany, France and Italy constitute 70% of Euroland’s GDP. Add the ECB’s intention to raise interest rates and prospects for 2006 appear to be diminishing. All of this plays to a weak Euro vis-à-vis the U.S. dollar as the ECB still will not be raising rates to anywhere near those of the Fed which plays to the dollar’s strength. The sideways march of the European economy is likely to play into European bond and CDS markets, which have been very tight over the last couple of years. We have already seen a deterioration in the business environment for paper and packaging companies as well as retailers; other industrial sectors (such as steel) could also be heading in the same direction. Staying long in European names could hurt – better to be light.
Seth Lopez
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