Confidence is growing amongst European companies, buoyed by a booming global market and gains in equity prices. The ‘eurozone’ economy started to move out of the doldrums half way through last year and business surveys already point to respectable growth of 2% to 2.5% this year, which is roughly the ‘trend’ rate.

It took longer to eliminate the eurozone’s investment overhang than it did in the US, but investment levels as a proportion of gross domestic product (GDP) are now back at the 1990s average. Balance sheet restructuring is advancing well and, assuming upbeat European business sentiment persists, investment should soon start to make a positive contribution to growth. Inventories – down in 2001 and 2002, and flat during 2003 – should recover, boosting production.

Exporters have coped with the appreciation of the euro by shaving costs and margins, and strong demand for specialist European plants and equipment, particularly from manufacturers in Asia and the United States, has helped underpin volume growth, more than compensating for the loss of a competitive edge. A further sharp rise in the euro would make life tougher for exporters, however, especially if it were to coincide with a levelling off in global growth, which is what we expect to happen as 2004 wears on.

And although business confidence has been rising since the middle of 2003, consumers remain cautious. This caution has been reflected in poor retail sales, which stayed flat during the run up to Christmas last year and actually fell in Germany, despite heavy discounting. That’s what makes the eurozone a ‘two-speed’ economy.

Hard at work?
Employment has been slow to recover during the upturn and there are signs that companies are now laying off workers to trim costs, while households in Germany are also disappointed over increased health costs and indirect tax increases, which have offset promised tax cuts. The export-led economic pick-up in growth should eventually improve job prospects, but as long as labour markets remain weak, confidence and consumption will too.

Another key constraint is that governments are trying to restore public finances, and can offer little, if any, support to growth. Fiscal policy is likely to be neutral at best for the region as a whole, with tax cuts being clawed back in the form of higher social charges and lower subsidies.

Reform has accelerated over the past year, though, with France having pushed through pensions changes before setting about its expensive health care system and working on tax cuts. Germany has achieved labour-market reform and cuts in taxes and subsidies this year, though by half what was originally proposed, and Italy is pressing on with pensions reform as well. The enlargement of the European Union should bring further impetus to European liberalisation.

THIS ARTICLE IS REPRODUCED COURTESY OF SMART INVESTOR MAGAZINE