UK: Flirting With Recession – Is the Eurozone Going to Grow at all This Year?

In the markets, 2004 will be remembered for oil prices shooting through $50 a barrel and the extraordinary weakness in the U.S dollar. We have seen the pound euro rate go through some wild fluctuations - anywhere from 1.41 to 1.52 - and the year has been filled with economic uncertainties which is the one thing markets dislike. In the U.K, interest rates have been rising to their current level of 4.75% whilst in the Eurozone, which has supposedly been on the brink of growth for some time, rates remained unchanged all year. In recent months the euro has strengthened rapidly as the currency has been seen as a successor to the fallen dollar. There has been much talk of governments increasing their reserves of euros at the expense of the out of favour dollar. There has even been talk that OPEC will start to price oil in euros rather than dollars which would be an astonishing move.

As always, interest rates hold the key to currency values. And the key to interest rates is growth (or lack of it). After an upbeat first half of last year, growth in the 12 country Eurozone had slowed sharply towards the end of 2004 as exports slowed and household spending remained flat. In the run up to the New Year, European commissioners were lining up to revise their economic forecasts for 2005, having been rather upbeat about prospects 12 months earlier. European Monetary Affairs commissioner Joaquin Almunia said in December "We have become somewhat more worried as some of the downside risks that we presented then may be materialising now. I would argue that the Eurozone is flirting with recession" It is entirely possible that there will be no interest rate rises in the Euro zone in 2005. In fact there is a genuine possibility that there may need to be an interest rate cut.

It is fair to say that the risk of a mild recession resulting from the double-whammy inflicted by high oil prices and a strong euro has significantly increased, the reasoning for which is straightforward:On the domestic production front many Eurozone manufacturers would be priced out of the market if they kept current selling prices completely unchanged. This is because they face competition from manufacturers outside the zone whose goods are now cheaper. However, competition is less intense in these domestic markets than overseas, where manufacturers dominate. Here, European producers are likely to have to absorb the shock of an expensive euro by limiting the rise of their prices in local currencies and squeezing profit margins accordingly, thinking that maybe the overvaluation of the currency is temporary. Their profitability dented, companies are likely to trim capital spending, which so far has been the most resilient part of demand in Europe. This asymmetry is the main reason why deflation should be relatively limited. Even so, we expect foreign producers to increase their market share in Europe; put another way, import substitution will also take its toll on domestic production. On top of this situation, global demand may slow throughout 2005 which, with a strong euro, will exaggerate the position for the euro zone and make any recession worse. A member of the ECB is quoted as saying "excessive volatility and disorderly movements in exchange rates are undesirable for economic growth" The ECB are aware of how damaging a continued strong euro could be and there is always the possibility that they may intervene to stem any further strengthening.

In the U.K the Bank of England appear to have done enough in the short term to stop the housing bubble bursting and contain consumer debt. Retail sales are falling and house prices are declining. As long as both elements remain stable, interest rates in the U.K will remain on hold for most of the year. Of key importance will be the price of oil over the coming months. If a high price is maintained then a recession could occur on a global scale and not be limited to certain areas.

As uncertainties continue we would expect the exchange rate to trade within similar ranges as this year. Towards the second half of the year the oil price should come back into line and the dollar should begin to firm. This should allow the Eurozone to begin a period of growth that may well allow the ECB to begin to raise interest rates towards the end of the year. We would envisage a continued slowdown in the U.K housing market for most of next year with the Bank of England keeping rates on hold certainly for the first half of the year. There seems to be no pressing reason for U.K policy makers to increase rates and on this basis, the Pound is unlikely to strengthen considerably. Whatever happens, I wish you a prosperous 2005.

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