Cost cutting is the new corporate buzzword across Europe

Alan Thompson Economist, at Scottish Widows Investment Partnership (SWIP): Euro area economic activity is contracting sharply, with survey evidence suggesting that there will be no quick rebound. Despite the pickup in EC and PMI survey based indicators, they remain deep in recession territory. The financial engineering of the last few years, and the development of a shadow banking sector, led to risk being systemically underpriced, a situation which is currently being rapidly unwound. The financial sector appears to have stabilised, but the economy is only just beginning the adjustment process to a credit constrained environment, which is likely to be arduous for both the consumer and the corporate sectors. Indeed, consumer and business confidence indicators remain at extremely low levels, reflecting the strains of this adjustment. In addition, although the external environment appears to have stabilised, the world economy is expected to record the deepest recession since 1945, which will constrain net export growth. We expect euro-area GDP to contract by 3.9% in 2009, with only modest growth of around 0.5% in 2010.

The poor economic outlook and the difficulty in raising finance, is leading to credit rationing in the corporate sector. Corporate issuance remains extremely expensive, with some companies simply unable to raise finance regardless of the cost. As such, new projects are being pulled, and ongoing projects are being reassessed in light of higher financing costs. Cost cutting is the new corporate buzzword, with only modest pay rises, along with reductions in inventories and lower levels of employment.

The household sector is likely to remain constrained for a period of time, as the labour market deteriorates and household wealth continues to fall. Lending to households has all but ground to a halt, suggesting that both the supply of lending and the demand for lending has slowed sharply. And although car sales have recovered modestly, this reflects government subsidies rather than underlying strength. In addition, the labour market is deteriorating rapidly, with employment contracting in Q3 and Q4 and this trend set to continue, with the unemployment rate increasing to 8.9% in March. The pickup in unemployment, and the more widespread fear of redundancy, is likely to lead to an increase in the savings rate. However, on a more positive note the euro area savings rate does not appear to need a step adjustment as it does in many Anglo-Saxon economies.

Banking sector issues remain. Europe's banking sector has been recapitalised, but a number of question marks remain regarding loans to Eastern Europe. Lending data from the ECB confirm that credit expansion has slowed sharply in both the corporate and the household sectors. This might suggest that as in other countries the banks have further write downs to make, and that further recapitalisations will be necessary. In particular, the exposure of many European banks to property lending in Eastern Europe remains a cause for concern, with a number of eastern currencies appearing fragile. Falling property prices along with potential devaluations suggests that the likelihood of a large number of defaults is increasing sharply. A functioning and sufficiently capitalised banking sector is an essential prerequisite for economic recovery.

The economic slowdown has been widely spread across the euro area. The slowdown may have started in countries with inflated property prices and over extended consumers, but it has since spread to the entire euro-area. Spain and Ireland were the first victims suffering from property crashes, along with the fallout of the banking sector. But collapsing world trade and the corresponding impact on industrial production has led to a spill over of the recession into export-led economies such as Germany. These economies traditionally rely on external trade as the engine of growth, but with the downturn in trade, and stagnant domestic demand their outlook appears bleak. In addition, the trade weighted euro remains at elevated levels which is likely to limit export growth, especially against sterling and the Swedish krona.

Inflation is set to stay low, constrained by low wage growth and the reduction in the price of oil. The world economy is operating significantly below full capacity, which is leading to a growing output gap and significant increases in the unemployment rate. The bargaining power of employees is diminishing as the labour market continues to deteriorate, with unions and employees eager to prevent redundancies. In addition, in the current economic environment retailers are reluctant to raise prices for fear of losing business, or are offering discounts to entice customers. As such, consumer price inflation fell to just 0.6% in April, and is set to average just 0.5% in 2009 and 1.7% in 2010.

Official interest rates appear to be at their lowest, but non-conventional measures will support the economy. The absence of inflationary pressures, along with the sharp contraction in economic activity has led to the ECB reducing interest rates to a trough of 1%. In addition, the ECB has announced its intention to purchase covered bonds which should provide additional support for the financial sector, while the introduction of operations with a 12 months maturity implies that rates are likely to remain on hold for a minimum of 12 months.