How will Europe fare if the US slows this year? According to the received wisdom, the ability for Europe, and the rest of the world, to “decouple” from the US will depend on the severity of that downturn.
Nouriel Roubini earlier this month pointed to a chapter in the IMF’s World Economic Outlook, which held that the world would be able to decouple from a US slowdown if the US experiences the fabled ’soft landing.’ But in the event of a hard landing, no such decoupling would occur.
The IMF also thinks that decoupling is more pronounced when an upset to growth is idiosyncratic to the US, such as a housing recession, and less so when shocks are global or common. This means (though Roubini on this point does not concur) that spillovers are likely to be smaller this time round, as the US slowdown is being prompted by a US-centric shock.
The idea that European growth can withstand the drag from a US slowdown is gaining traction, finds Merrill Lynch’s latest survey of fund managers.
Life seems pretty rosy. In fact, it’s almost as though February’s upset never happened. Stocks have rallied, fuelled by renewed risk appetite among investors.
But what hasn’t changed is the pessimistic outlook that respondents have for corporate profits. “Whatever the reason for the turnaround in risk appetite, it’s not because investor feel more confident for the outlook for corporate earnings. Quite the opposite in fact,” says David Bowers, from Absolute Strategy Research and consultant to Merrill Lynch. “Investors are turning a blind eye to earnings and are focusing on undemanding equity valuations and the scope to return cash to shareholders.”
A net 38 per cent of respondents expect profits growth to deteriorate over the next 12 months - the most negative outcome this year.
But the move back into equities is marked by growing regional disparities. A net 18 per cent said they thought the US to be the most overvalued equity market in the world, while a net 26 per cent believed the eurozone the most undervalued. The story is similar in earnings outlook - with a net 38 per cent see the outlook for profits as brightest in the eurozone, while a net 42 per cent see it as weakest in the US. That is the widest gap recorded since April 2001, when the question was added to the survey.
“Fund managers clearly believe the eurozone is able to decouple from a US corporate profits slowdown,” says Bowers.
Merrill’s head of European Equity Strategy Karen Olney has one explanation. The US now accounts for just 14 per cent of eurozone exports, she notes, compared with emerging Asia, China and emerging Europe at more than 31 per cent: “Europe’s proximity to fast-growing emerging markets has allowed it re-orientate growth from the west to the east.”
For the first time since 2001, Merrill estimates that the Eurozone’s GDP, helped by strong domestic growth and a burst of exports to the east, will grow faster than the US, at 2.5 per cent in 2007 compared to 2.3 per cent.
With increasing ties eastward, should we then be more concerned that Asia will be the one to catch US influenza?
Merrill’s Economist TJ Bond is unconcerned. He wrote this week: “We’re doubling down on our decoupling view. Previously we subscribed to the (now consensus) view that Asia could withstand a US ’soft landing’, but not a hard one. Our level of confidence has increased. We now think Asia could withstand a US recession.”
The risks to this picture? An unanticipated tick-up in inflation, perhaps, or a turn in the credit cycle. “It seems to get pushed out by 12 months every year,” says Olney, with the likes of Moody’s and S&P currently looking for default rates of 2.3 per cent at the end of this year. Back in September 2006, that number was going to be 3.4 per cent.
“Perhaps there’s enough liquidity out there…to keep the game going,” says Olney. “The craziness could go on another 12 months but each leg into it the risks are rising.” With each reprieve though, the ride gets bumpier.
