The consensus view is that an economic strategist needs a magnifying glass to detect growth in the Euro-zone economy, so far does it lag behind that of the US and UK economies. Yet currently the Euro-zone is experiencing growth that is clearly visible to the naked eye.
Surveys from two leading European economic institutes, the Germany’s Ifo and Italy’s ISAE, plus reports from Belgian, French and Spanish manufacturers, have found stronger than expected improvement in the business climate, while the improvement in demand has reached its highest level for three years.
Annamaria Grimaldi, pan European specialist in Morgan Stanley’s global economics team in London, says the signs are encouraging: “Our business cycle analysis tools have turned more positive on growth, suggesting that the economy might even have accelerated slightly in the past month.
“The upside surprise in the surveys came in particular from demand, which finally recorded a significant improvement, breaking its long-term average and touching a level last seen in April 2001.” This boost to demand seems to have come from exports, she suggests.
Deutsche Bank’s research team in Frankfurt also note that Euro-zone exporters have benefited from the increasing global demand, and they predict that exports could increase by 7% this year: “Despite the strong euro, EMU exports will continue to grow strongly. This will trigger higher investment and stabilise employment.”
Tony Dolphin, director of economics and strategy at Henderson Global Investors, points out that European recoveries tend to be led by external demand, since the European economy has always been less sensitive to changes in interest rates than the US and UK economies - partly because of the structure of the housing market.
“The European economic cycle also tends to lag the US and UK cycles. One consequence of this is that European real GDP growth in 2005 is expected to be higher than in 2004, while growth in the US and the UK is expected to slow.”
This will favour Euro-zone equities, he says. Last year equity markets were in the so-called ‘sweet spot’, when economic and profits growth were strong and interest rates stayed low. This year, US and UK equities have moved out of the sweet spot, but because Europe is lagging in the cycle, European equities may remain in it for somewhat longer.
“Output growth in 2005 looks like being stronger than in 2004 and interest rates could stay at present levels through to the middle of next year. This should be supportive of European equity markets,” says Dolphin.
Europe’s long-term economic underperformance need not lead to equity market underperformance, he says “Since the beginning of 1996 returns from European equities have marginally outperformed returns to US equities, despite real GDP growth in the US averaging about 1.5% a year higher than in the Euro-zone. It appears that quoted companies in the Euro-zone are able to match their US counterparts, even when the economy is underperforming.”
Dolphin points out that although governments in Europe have been criticised for not pushing through structural reform, companies themselves have been restructuring to maintain competitiveness and boost profit margins. These efforts are reflected in relative equity market performance.
“Since these efforts are continuing, there is every reason to believe that European equity markets will keep up with the US market in the future. And for the next year or so there are reasons to believe that European equities might outperform,” he says.
Finally, the fact that the consensus view on Europe’s growth prospects is so gloomy creates the conditions for ‘positive surprise’, Dolphin suggests: “Output growth could surprise by its strength in the second half of the year - something that is unlikely in the US and the UK where expectations are already high.”

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