The contrasting economic fortunes of the core of Europe and those at the edge of, or outside, the euro area persist. The consensus view has been that euroland economic growth will begin to accelerate this year and that there will be a slowdown (or even recession in the case of the UK) in the periphery.
This view looks like being confounded. Unemployment in euroland’s biggest economies has stopped falling. Consumer confidence will slip unless those out of work start to get fewer again. If not, real wage gains will get saved, not spent. Then the widely expected recovery in core Europe during the second half of this year will founder. In the UK, by contrast, there are signs of growing consumer confidence, boosted by low mortgage rates and a buoyant labour market in services.
Europe’s industrial sector is struggling. Order books are thin and capacity utilization is declining. So Europe’s consumers must become the mainstay of any recovery this year. With real wage gains of 2% to 3% in the bag for 1999 in Germany and France, the ingredients for a consumer-led recovery are certainly there. But in the absence of household confidence, those wage gains are just as likely to be saved as spent. That’s why the downtrend in Europe’s core confidence indices is so critical.
The catalyst has been an uptick in unemployment in both Germany and France. I reckon the job outlook will deteriorate further. First, the German SPD-led government’s new legislation, which imposes social-security contributions on previously exempt low-paid jobs – those with earnings of up to Dm630 ($342) a month – will almost certainly reduce the number of part-time workers.
Second, in France (and Italy, for that matter) the imposition of a 35-hour week without loss of pay (from January 2000) will raise unit labour costs substantially (by a net 4% to 5%). That will limit the corporate sector’s ability to take on new workers without compromising profits.
Third, corporate consolidation will lead to further job losses in those European countries with the highest labour costs. Merger and acquisition activity across the continent was worth more than $800 billion last year, of which cross-border deals involving German companies accounted for almost $100 billion. Rationalization is inevitable if such mergers are to make business sense.
The implication for monetary policy in the EU is clear. Without recovery, the European Central Bank will have to cut interest rates again, from the current low of 2.5%. Indeed, ECB president Wim Duisenberg’s “that’s it” comment as he announced the last 50 basis point rate cut might end up rivalling George Bush’s infamous “read my lips” promise on taxes. Should a lasting settlement for Kosovo be achieved in the coming weeks, the euro could bounce by 1% to 2% in the near term. But further ECB interest-rate reductions will undermine the single European currency over the next six months.
In contrast, the UK’s boom-bust cycles look to be a thing of the past. With the Bank of England in charge of interest-rate policy, the medium-term goal of sustaining an underlying inflation rate of 2.5% appears credible. Sure, real short-term interest rates at 3% are higher than at the end of previous downturns. But the flexibility of the UK economy in general – and of the workforce in particular – means that this presents little obstacle to recovery.
That’s because in the UK, just as in the rest of the world, long-term bond yields have dropped to historical lows. That makes a huge difference in a country where most households borrow heavily to purchase their own homes. The housing affordability index, which compares the cost of financing the average mortgage with disposable income, is once again at historical lows. That points to a pick-up in house prices.
The other factor that will support UK consumer confidence in comparison with core Europe is the job market. The newspapers have been full of doom and gloom about manufacturing jobs being lost. But manufacturing now accounts for just 20% of UK GDP and total employment. As in the US, it’s the service sector that matters.
And here the signs are still good. Service-sector employment is in positive territory. And average earnings growth was back at 5% year-on-year in February 1999. It’s small wonder the UK consumer is full of the joys of spring. Along with the confidence index, retail sales are accelerating again.
In the two years since the new Labour government granted further independence to the Bank of England, 10-year gilt yields have fallen from 7.2% to 4.8%. Over that time the spread between gilts and German Bunds has come in from 130bp to 80bp and that over US treasuries from +50bp to minus 65bp. Much of this is a result of the economic slowdown, but it also stems from the perception that single-currency membership is now something close to a racing certainty, rather than an outside chance.
But with consumption-led growth set to accelerate, that outperformance is unlikely to continue. There may be one more 25bp UK interest rate cut to come but it will almost certainly be the last. So from here, I expect UK equities to rule the roost. Corporate profit growth should reach 7% to 10% for the year. And relative valuations are attractive. Concerns about manufacturing competitiveness shouldn’t be a major constraint: more than half the UK’s export revenues from manufactures are actually attributable to foreign-owned companies.
The blot on the landscape is sterling. The trade account has been deteriorating, but lower-than-normal profit repatriation by foreign banks (due to emerging-market losses) has saved the current account. It’s unlikely to do so for long: I expect a 1.5% to 2.5% of GDP current-account deficit to develop next year. That will hit the pound, which should fall to Dm2.75 or e1.45 or $1.55 by the end of the year.
David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com
