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The strength of European growth has been very visible in most of my recent trips – although the dividends are not always as positive as the press would suggest. From traffic gridlocks in the Netherlands to the desperate search for hotel rooms in several European cities, the euro zone has definitely surprised most economists as well as some business travellers in 2007. Gone are the days when the discussions about European growth could be filed quarter after quarter under the chapter ‘lack of aggregate demand’ with the predictability of Bill Murray’s daily routine in the movie ‘Groundhog Day’. The first half of 2007 has in fact confirmed that you can throw obstacles like a 3% value added tax (VAT) increase in Germany at the European growth locomotive without derailing it. In reviewing the outlook for the next few quarters, a few themes seem to suggest that this euro zone recovery might have more stamina than expected.

Strong Cyclical Tailwinds
The euro zone economy (Chart 1) finally overtook the U.S. economy in terms of growth in the last quarter of 2006. Whilst this achievement is not unprecedented and happens at a time when the U.S. economy is slowing down, the tailwinds that have supported this recovery seem firmly in place.

The first factor that explains the upward surprises in European growth versus expectations is the financial strength of the corporate sector. The shedding of unprofitable investments over the last few years combined with the restructuring of the labour force has led to European corporations experiencing the highest growth in profits in over a decade. This focus on restructuring happened at a time when European exports were a lot stronger than expected due to the strength of the emerging economies where Europe has had a strong market share. As a result, capacity utilisation in Europe stands just under 85%, a level last seen (briefly) in early 2001. In some sectors in Germany, capacity utilisation rates are even above 90%.

New job creation is the second factor driving the current recovery. A net balance of 15% of workers have no fears about finding a new job, a survey of the European Commission shows. This level is almost 20% better than the levels seen at previous peaks in economic activity. As a result, the conditions for consumer demand to start increasing are all in place. Strong employment, a loosening of lending standards and an increase in the household savings rate since the introduction of the euro suggest that Europeans have the wallet – if not the will – to spend money. Rising consumer sentiment suggests consumer spending is likely to turn higher over the next few quarters.

A Play on Strong Emerging Economies
The big structural change for the euro zone was the expansion of the EU, which added ten countries in 2004 and two more in early 2007. The 12 new members increased the population of the EU by approximately 230 to 550 million. What is more relevant, however, is the gradual convergence of these countries’ interest rates and lending standards with the rest of Europe (essentially a replay of what happened among EU countries before the introduction of the euro). The fiscal tightening and lower inflation in central European countries are leading to interest rates that have almost converged to euro zone levels, allowing central Europeans greater access to consumer finance.

The benefits for the euro zone are quite obvious. Exports to central Europe are growing at just under 20% (six months on six months seasonally adjusted annual rate) and by value represent 19% of total European exports. David Woo from Barclays highlighted recently how advantages from the emerging markets growth are stronger for Europe than the U.S. in two ways. First, the total share of euro zone exports going to emerging markets was around 10% in 2006 compared to 6% of total exports for the U.S. Second, given the fact that exports are a larger proportion of euro zone GDP, exports to emerging markets could have added as much as 0.5% to euro zone GDP growth in 2006 versus only 0.2% for the U.S. If above average growth in emerging countries continues to drive trend growth globally, Europe will be a clear beneficiary.

Euro Zone Growth Rates Likely to Benefit Core Countries
Eight and a half years after the introduction of the euro, it is becoming clear that not all countries are equally competitive within the euro zone. The current recovery is likely to be characterised by a continued outperformance of the core countries over the periphery. A recent analysis by Morgan Stanley showed that countries like Spain, Portugal and Greece had current account deficits in excess of the U.S. deficit in 2006 whilst countries like the Netherlands, Austria and Germany have current account surpluses in excess of 2%. This situation is certainly the by-product of capital mobility but reflects also diverging domestic dynamics and to some extent declining competitiveness in some periphery countries.

The current account picture is mirrored by the financial balance of the non-financial corporate sector. While corporate deficits in Germany were close to zero in 2006, the deficit of non-financial corporates was approaching 8% in Spain. This problem is compounded on the household side by the fact that the mortgage market across the euro zone remains very different from country to country. Whereas mortgage rates are mostly variable in Italy and Spain and therefore impacted by a tight monetary policy, in the core euro zone countries most mortgages are still fixed for 10 years if not longer. As a result, monetary policy of the European Central Bank (ECB) appears unlikely to affect everybody in the same way. Overall it seems that – whilst this recovery is well supported – it will benefit mainly the core euro zone countries.

Some Inflation Clouds on the Horizon?
The ECB is looking remarkably ‘ahead of the curve’ in controlling inflation compared to the neighbouring central banks in the U.K. and Scandinavia. In spite of an inflation rate below 2%, there are some clear threats to the euro zone inflation outlook. Core inflation has been heading higher since the end of 2005 as the negative output gap of the euro zone has been eroded by above trend growth. Recent surveys have indicated shortages of material and equipment as well as a rise in labour shortages, although these remain well below the peaks seen in 1990 and 2000. To some extent, these upward pressures combined with volatile components such as food prices have been offset by the benefits of a strong currency. Nonetheless, the pass-through of inflation is likely to be more direct going forward than it has been over the past two years.

The threat to inflation stability is compounded by two other factors. The European consumer price figures currently include housing only in terms of the level of rentals and do not include a component related to the cost of owner occupied housing. This concept has been in the news recently as it is one of the more volatile components of U.S. inflation. In the U.S., rather than directly measuring the cost of buying and maintaining a home, the owners’ equivalent rent measures the cost of housing as what an owner would receive for renting his or her house. Morgan Stanley in a recent study concluded that if the euro zone adopts the same methodology (planned for 2009), it would cause harmonised CPI figures to rise between 0.3 to 0.6%.

This problem is exacerbated by the inclusion of central European countries into the euro zone from 2010 onwards. Whilst some countries have brought inflation down to the European average, most of them still have a higher and more volatile inflation rate, which would increase the current European CPI figure by an estimated further 0.1%. These structural issues are certainly not something of concern in 2008 but will gradually appear on the radar screen over the next 18 months and will have to be considered by the market in pricing ECB rates.

Strategy Implications
How does an investor adjust strategy in a euro fixed- income portfolio in view of these macro trends?

• From a duration standpoint, the first conclusion is to continue to underweight duration. The strong tailwinds supporting the current recovery combined with the positive impact of emerging market growth on European exports suggest that the ECB will have to go beyond neutral (i.e., beyond 4.25 - 4.5%) to limit upward inflationary pressures.
• Diversification of exposure out of euro zone bonds into U.S. Treasuries and U.K. Gilts is likely to be beneficial as the more advanced cycles in these countries suggest that there is less upside in yield. We would expect euro yields to gradually converge with U.S. yields.
• The greater divergence in economic growth is likely to result in greater spread differences between different euro zone countries than we have experienced over the last couple of years. The current environment suggests that portfolios should be overweighting core euro zone countries versus the periphery with particular underweights in countries like Spain, Portugal and Greece.
• The structural issues related to one-off increases in European inflation are likely to lead to a steeper curve as it will remain unclear how the ECB will adjust its monetary policy to this evolving situation. We also consider that the move by Sovereign Wealth Funds out of fixed-income securities into riskier asset classes will unwind the yield curve conundrum that has been observed over the last few years. We would recommend European fixed-income portfolios to avoid intermediate maturities (5 – 10 years) as those are likely to be harder hit by this uncertainty.

Emanuele Ravano
Managing Director