January 28, 2008

Behind Market Turmoil, Europe Is Weakening

European financial markets breathed a sigh of relief on Jan. 22 as share prices rebounded after the U.S. Federal Reserve pushed through an emergency three-quarter-point interest rate cut. The Fed's action, which followed a day of panic selling on global bourses, underscored Europe's vulnerability to a potential U.S. recession. After plunging in the morning -- following a rout on Jan. 21 and early declines in Asia -- Britain's FTSE-100 and France's CAC-40 ended the day up more than 2%, while Germany's DAX edged down 0.3%.

European politicians wasted no time chastising the U.S. for triggering the crisis through years of reckless deficit spending. "This is not at all the situation in our European economies," European Union Economic & Monetary Affairs Commissioner Joaquin Almunia told reporters before a meeting of EU finance ministers in Brussels.

But it's also becoming clear serious trouble is brewing in Europe's own backyard. From rising labor costs in Germany, to precarious housing markets in Spain, to a painful credit crunch in Britain: "There's a serious weakening of the European economy going on, independent of what's happening in the U.S.," says Laurent Bilke, a London economist at Lehman Brothers (NYSE:LEH - News).

Forecasting 5.5% Profit Drop

Ominous signs are everywhere. The euro zone inflation rate hit a six-year high of 3.1% in December, and German unions are negotiating hefty wage increases that could send it still higher. After a prolonged property boom, Britain is now struggling with its own version of the U.S. subprime crisis (BusinessWeek.com, 11/20/07) "Exactly the same (kinds of) mortgages were sold to British investors, and that will start to hurt the financial-service sector," says Ian Harnett, managing director for European strategy at Absolute Strategy Research in London.

Old World corporate earnings look set to slide, too. Goldman Sachs (NYSE:GS - News) is forecasting profits at European companies will drop 5.5% this year as they struggle with inflation, tight credit, and the strength of the euro, which cuts deeply into the competitiveness of European exports.

Financial troubles in the U.S. have exacerbated these problems. The subprime crisis has clobbered Europe's financial sector, with banks such as Switzerland's UBS (NYSE:UBS - News) and Britain's Barclays (NYSE:BCS - News) and Royal Bank of Scotland (NYSE:RBS - News) taking huge writedowns in recent months (BusinessWeek.com, 12/10/07) The U.S. also has allowed the euro to rise relentlessly against the dollar -- and the Fed's rate cut could fuel an additional rise. Every 10% rise in the euro's value against the dollar knocks 3% off euro zone corporate earnings growth, Goldman Sachs estimates.

U.S. Still the Epicenter

True, the EU isn't sliding into recession. Although economists have scaled back their growth forecasts, most still think the region's economy will grow by at least 1.5% this year. "The risks are increasing, but the U.S. is still the epicenter of the turmoil," says Ken Wattret, an economist at BNP Paribas (BNPP.PA) in London.

The focus now is on Europe's central bankers: Will they or won't they follow the lead of the Fed, which has already hinted more rate cuts are on the way? The Bank of England on Jan. 22 ruled out an emergency intervention, but market-watchers think it could cut rates as early as its next monetary policy meeting, Feb. 7. That could give a boost to British consumer spending, which has slumped in recent months (BusinessWeek.com, 1/9/08). Britain's 5.5% interest rate is the highest of any leading industrialized country.

From Panic to Pain

The European Central Bank, which has held firm against rate cuts for fear of sparking inflation (BusinessWeek.com, 1/18/08), will probably hold out a bit longer. But a euro zone rate cut by summer is all but inevitable, says Amit Kara, a London economist at UBS. He predicts two ECB rate cuts this year, totaling half a percentage point.

European markets were in bear territory even before the Jan. 21 sell-off. The leading Paris and Frankfurt stock indexes are down more than 15% this year, and more than half of that decline occurred before Jan. 21. Similarly, the 5.5% decline in Britain's FTSE-100 index on Jan. 21 was part of a 13.6% slide since the beginning of the year. The panic may have subsided, but Europe's economic pain almost certainly hasn't.

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