European Economic Recovery Will Lag U.S., Norway in Best Position, Says RGE Monitor

With European equities hitting an 8-month high today, this would seem to be an opportune time to review the economic outlook for the region.  Thankfully, RGE Monitor, an economic think-tank, has just released a preview of its outlook for Europe, broken down by zones.  According to RGE Monitor, Norway, due mainly to its healthy banking system and net savings, is seated in the best position to take advantage of a global economic stabilization/recovery.

European equities staged a broad-based rally today, hitting a fresh eight month high as a string of mostly well-received corporate earnings convinced investors the recent run should continue.

The pan-European FTSE Eurofirst 300 gained 1.1 per cent to 920.84. The French CAC 40 added 1 per cent to 3,400.44, while the German Xetra Dax rose 0.6 per cent to 5,302.79.

As with all other equity markets around the world, Europe has enjoyed a rally based on the perception that global economic fortunes are turning around.  But the outlook is not all that cheerful, while at the same time being not as bad as expectations were eight months ago.  Investors may be best served to wait and watch the data unfold before making any firm commitments.

A preview of the European economic outlook from RGE Monitor is reproduced below:

European Monetary Union

RGE Monitor expects the cyclical recovery in the eurozone–led by Germanyand France–to lag recovery in the U.S., the BRICs and non-Central and Eastern Europe (CEE) emerging markets. Among the main factors muting Europe’s recovery in 2010 are a permanent decline in potential output; unwinding pressures of large internal imbalances leading to deflationary pressures; a more restricted monetary and fiscal policy response compared to the U.S. and especially to China; a leveraged financial sector with too-big-to-fail institutions and too-big-to-save features; and a strong reliance on bank funding by the corporate sector subject to a larger financing gap than that seen in the U.S.

In order not to impair the banking sector’s lending ability permanently, a quick disposal of bad assets is warranted. Lending to the private sectoris slowing quickly, and for small and medium sized enterprises with no access to capital markets, bank credit lines represent the only recourse for liquidity. Based on IMF and ECB estimates, total bank losses in the eurozone will amount to between $650 billion and $900 billion, implying substantial additional recapitalization costs.

Germany’s specialization in cyclical industrial goods, and its export-led growth model, have been particularly damaging to growth. Going forward, RGE cautions that given the likely reticence of the U.S. consumer in the medium term future, an exclusive reliance on export-led growth is not advisable. France’s more balanced domestic demand-led growth model has served it relatively better. Italy is grappling with a structural and long-term decline in its relative living standard–a situation that requires a radical overhaul of structural impediments in product and labor markets. Spain’s challenge lies in an expected 20% unemployment rate and deflationary pressures to restore relative price competitiveness. Ireland is among the developed countries hit hardest by the crisis and its large banking sector (relative to GDP) represents a contingent liability despite the country’s commendable ‘bad bank’ scheme.

United Kingdom

The UK’s mainstay is its financial sector, which has accordingly received substantial government support. The country’s strained fiscal position puts more radical solutions for unviable banking institutions on the table for regulators, who are openly discussing options like splitting banks that are too-big-to-fail. The lending environment is equally important for the housing market, which is fundamental to the British economy.

Central and Eastern Europe

Among emerging market regions, CEE economiesare experiencing the steepest roller-coaster ride in terms of growth. After exceeding global growth averages for the last decade, regional growth is plummeting in 2009 and is expected to underperform both emerging Asia and Latin America. All EU newcomers in the region are either in or headed for recession. A dangerous combination of falling exports and slowing capital inflows is behind the bleak growth picture. The hardest-hit economies have tended to be very open, with wide current account deficits in recent years and high levels of foreign currency borrowing.

Not all CEE economies are in the same boat. The Czech Republic and Poland, for example, are considered relatively healthy and are expected to experience relatively mild contractions in 2009. Those in more dire straits–Estonia, Latvia, Lithuania–are facing double-digit contractions. Hungary, Latvia, Romania and Serbia have already turned to the IMF for financial assistance, and more are likely to face severe downturns.

RGE Monitor points to the following as possible downside risks to regional growth:

Risk of regional financial contagion (e.g. the possibility of spillover effects in the event of a Latvian devaluation)
Potential for a cross-border banking crisis
Rising political instability
Repeat of January gas crisis

Given the strong financial and trade linkages with Western Europe, a recovery in Eastern Europewill not come until its western neighbors’ economies improve. That means the region’s recovery will lag behind that of Western Europe. Meanwhile, the downside risks described above could further delay recovery. And even when recovery comes, RGE expects sluggish positive growth in the medium-term, rather than a return to the soaring growth rates seen earlier this decade.

Nordics

After strong growth earlier this decade, all five Nordic economies are now in the midst of recessions. These are small, open economies that have been hit hard by slumping external demand for their exports. Given their strong public finances, Nordic economies, with the exception of Iceland, have resources available to cushion their contractions. Ultimately, however, economic recovery in the region hinges on a global recovery.

Norway’s economy will experience the mildest GDP contraction in the region in 2009, while Iceland will see the sharpest contraction. Norwayis the best placed for a quick rebound to positive growth given its sizeable buildup of oil revenues and its large maneuver room on fiscal and monetary policy. Recovery in Finland and Sweden is tied to a revival in demand for their export products. The global production slump has been particularly bad news for Finland and Sweden given the large share of capital goods in the makeup of their exports. Not surprisingly, these economies are facing the region’s sharpest contractions in 2009 behind Iceland. Stress in the Swedish banking sector could result in a more protracted recovery there.