EXPECT EUROZONE HARDLANDING FOR 2008
by Krassimir Petrov, PhD. The American University in Bulgaria. March 4, 2008
Economic reality will likely prove forecasts of major international institutions about Europe's 2008 growth prospects wrong. So, let us first see what they think; then we will see what I think and why.
A number of major institutions have provided their 2008 Eurozone economic forecast. Interestingly, many of them just recently (December 2007) revised down their forecasts. Here is a quick survey: 2.1% by IMF � revised its 2008 growth forecast for the Eurozone down from 2.5%; 1.9% by OECD; 2.0% by ECB, the midpoint of their range, down from previous midpoint of 2.3%; 2.0% by EU Commission; 1.8% by ING Financial Markets.
Still, until the end of January, most have only modestly lowered their economic forecasts from about 2.4% in 2007 to about 2% in 2008. They see a Eurozone slowdown, maybe 0.3-0.4% lower than 2007.
I see a Eurozone hard-landing. I see major recessionary forces that forecasters conveniently downplay or ignore. I see the 2008 Eurozone economy in a tailspin. I see it on the brink of recession in early 2009. I believe that they all these "reputable" international institutions are too complacent and detached from reality.
A 1-2% slowdown is definitely possible. Even a cursory look at the latest Eurozone soft-landing in 2001 suggests that it is possible. For example, a 4% growth in 2000 was down to barely 0.5% by 2002. The point is that a 2% drop in growth in just one year is perfectly normal. Thus, while this is certainly possible, the big question is whether it is likely.
The issue really boils down to this: will Eurozone's growth rates in 2008 shave off just 0.3-0.4% or more like 1.5-2.0%. In disagreement with all major institutions, I believe in the second. I have ten good reasons to make this strong claim. So here they are.
1. Strong Euro. Over the last couple of months, the Euro has risen a lot. The Eurozone is export-driven, so this chokes the export sector. Currency hedging still largely mitigates the problem; not so in 2008. The ECB is not likely to take measures to weaken the currency. Thus, in 2008 the Euro is likely to get much stronger relative to the dollar. Just watch it happen.
2. Tight Credit. Somehow, major institutions explicitly assume that the Credit Crunch will not spill over into the real economy. This is what they assumed also for the U.S. economy. The U.S. reality proved them dead wrong, and so will the European reality. Only this factor alone could easily slow growth with 1%, possibly even more
3. Rising Oil Prices. True, oil prices in euro have not risen as much as in U.S. dollars. Still, they are up close to 50% in 2007, from about 40 Euro at the beginning to about 60 at the end. This has got to hurt the economy at some point, while Peak Oil will make sure that oil prices will remain stubbornly high despite pronounced economic weakness in the U.S. and Europe.
4. Rising Gas Prices. Putin really enjoys his energy grip over Europe. RIA Novosti reported on November 21 that �Gazprom intends to raise gas prices for Western Europe by 60% in 2008. Deputy CEO Alexander Medvedev, head of Gazprom Export, said on November 20 that gas prices for Western Europe might grow from the current $250 to $300-$400 next year.� This has got to hurt Europe�s economy.
5. U.S. Hardlanding. The U.S. economy is rapidly decelerating. Whether it avoids recession or not is irrelevant. Personally, I believe that it is already in recession. In either case, slowing U.S. demand for European exports is certain. I see a U.S. hardlanding and a stronger negative effect on the Eurozone economy.
6. Bursting Bubbles. Major real estate bubbles are already bursting in the U.K., Ireland, and Spain. Smaller ones in France, Portugal, Italy and Greece are just popping. By now, U.S. current experience should have convinced everyone that bursting real estate bubbles could drive an economy into a tailspin surprisingly fast. Moreover, drivers of Eurozone aggregate demand are countries with huge current account deficits: Spain - $126B, Britain $87B, Italy - $48B, and Greece $42B. Not surprisingly, these countries have wild real estate bubbles driving their demand, just like in the U.S. When their bubbles burst, the demand will evaporate.
7. Rate Hikes in the Pipeline. The ECB began its monetary tightening in December 2005. It ended its tightening cycle in mid 2007. Such monetary policy effects are usually felt strongest with a 12-24 month lag. The tightening has barely taken effect so far. It is in the pipeline and will have its strongest impact in 2008.
8. Stubborn ECB. The ECB is stubborn in its stance. In its December meeting, it did not cut rates. Moreover, it reiterated its strong anti-inflationary stance. Whether it cuts rates in March 2008 or in June 2008, its effects will not be felt fully until 2009. So, there is no monetary help in the pipeline at this moment.
9. Elevated Euribor. Euribor is the Euro interest rate that European banks charge each other, the equivalent of LIBOR for U. S. Dollars. Since the August Credit Crunch, the Euribor has been elevated 50-90 basis points above the ECB benchmark rate. This, however, is equivalent to the ECB having raised it benchmark rate by another half or three-quarters percentage points. Its decelerating effect will be felt in full force in 2008.
10. Comatose Bond Markets. Europe�s junk bond market is comatose. There has not been a single junk-bond issue since August. Even governments have major funding difficulties. Here is what the Financial Times reported on December 3, �A severe bout of illiquidity has hit eurozone government bonds, threatening to impair the ability of some governments and other borrowers to meet their funding needs in coming months, � �European government bond markets are facing challenges they haven't done for decades,� said Steven Major, head of fixed-income strategy at HSBC�.
I believe that these are major factors that will affect Europe�s economic growth in 2008. By far, the list is incomplete. The anecdotal evidence is there to fill a dissertation: major strikes in France, massive fires in Greece, LIBOR daily spikes of 20-50 basis points, collapsing Spanish economy, sharply lower consumer and investor confidence in Germany and France, etc.
Undoubtedly, most of my arguments rest squarely on monetary, financial, and credit issues. This is for a good reason that may escape the North-American reader. The European financial system is fundamentally different from the U.S. financial system. In Europe, equity markets are not as important as in the United States. Instead, the European financial system is heavily dependent on bank credit. Therefore, the European economy is much more vulnerable to bank problems than the U.S. economy.
The European economy is likely to surprise downward in 2008, and so are the European equity markets. Therefore, expect a full-blown equity bear market, although I would say that at this point the bear market is firmly entrenched.
Investment Advice: Conservative investors should cut down their long European equity exposures. Aggressive investors should accumulate gold and short major European indexes.
© 2008 Krassimir Petrov, Ph.D.