Global storm clouds gather over Europe

The MSCI Europe index is up by around 11% from its March low amid fading worries over the credit crisis and solid results from major European firms. But the outlook is far from rosy. It's becoming clear that "the global economic storm clouds have reached the continent", says The Wall Street Journal.

The IMF has slashed its eurozone growth forecast to 1.4% this year and 1.2% next (last year the eurozone managed 2.7%), while this week the European Commission also trimmed its forecasts, noting that both the global financial turmoil and the US downturn were proving more protracted than it had assumed last year. Germany's Ifo business confidence index unexpectedly slid to a two-year low in April, with a sub-index gauging prospects for the next six months at a three-year low. Similar indices in France and the Netherlands also dropped.

Exports have hitherto remained solid since foreign demand for Europe's wares is not very price-sensitive, as The Economist notes. Euro area exports to countries outside the EU comprise around 10% of GDP, of which about half are high-tech consumer durables or capital equipment highly prized in Asian economies who have trouble finding cheaper high-quality alternatives.

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Germany's exports are particularly skewed towards high-tech products. But the Ifo data, along with the slide in RBS's manufacturing purchasing manager index to a three-year low with the index for export orders signalling a contraction suggests that the strength of the euro and weaker external demand is "finally beginning to have an effect", says RBS.

Not only is there a global slowdown in demand, notes Ian Campbell on Breakingviews.com, but prospects in eastern Europe, a strong market for eurozone producers, "are fading fast". And the zone's "weaker links are tottering". Spain is slowing sharply after its housing bust and Italy is "stagnant".

Might consumers, who save around 14% of their income, come to the rescue? It seems not. High inflation which is also deterring the European Central Bank from cutting interest rates has squeezed budgets and dented confidence; a Bloomberg survey this week pointed to the biggest drop in eurozone retail sales in four years. In Germany, a sharp slide in retail sector confidence means it's "unlikely that consumers will pick up the slack" as global demand weakens, says Capital Economics.

As for the credit crunch, there are still plenty of writedowns to come from European banks, while Julian Callow of Barclays Capital says that banks are rapidly cutting back on new credit lines, portending a slowdown in lending later this year. Banks will also face new problems as trouble grows in the industrial sector, says Campbell. "Europe's health isn't rude at all."

But earnings estimates still look generous. Analysts expect stagnant average earnings for the firms in Germany's DAX index the major European market most sensitive to global growth, according to Goldman Sachs in 2008 but double-digit growth next year, when German firms are likely to begin feeling the full force of the slowdown.

Europe as a whole is set for an earnings slide of 16% this year, as opposed to the consensus forecast of +6%, says Morgan Stanley's Teun Draaisma, while the overall profit slide from the peak will be around 20%. European margins and returns on equity are at record levels, the US housing market has worsened, Britain is deteriorating and the crunch is set to hit continental growth.

Judging by previous market patterns in earnings recessions, the MSCI Europe index may have hit its bear market low in March, but stocks are likely to slide again and remain volatile until earnings trough, reckons Draaisma. Don't expect a new bull market until earnings rise again. That won't be soon. We are set for "a sustained period" of weak growth in Western economies "as the credit crunch impact takes a long time to play out".