European Economies Mirror U.S. Woes

Rising food, fuel and housing costs plus a credit crunch plague both sides of the Atlantic, but the weak dollar will continue to stimulate strong demand for U.S. goods and services.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

Mark Sfiligoj, Deputy Managing Editor, the Kiplinger letters

June 25, 2008

Europe is following in America's footsteps down a trail of economic woes: Sluggish growth, rising inflation and unemployment. Given the close relationship, that makes sense: The U.S. captures more European Union (EU) investment than any other country. For Germany, France, Italy, Spain and the Netherlands, it's the top export market outside Europe. For the United Kingdom (U.K.), it's the top, bar none.

EU economies are markedly slowing as revealed in our recent visit, which coincided with talks between President Bush and EU leaders. But while we expect the U.S. to be past the worst of its current downturn by year-end -- with modest improvement in 2009 -- Europe won't hit bottom until late this year or even early next. Germany will weather the slump better than others. Italy and Spain may suffer most.

Food, fuel and housing costs are soaring throughout Europe. The 12-month inflation rate for the euro zone hit 3.7% in May. A year earlier, it was 1.9%. Similarly, in the U.K., consumer prices in May were 3.3% higher than they were a year earlier. The previous year they rose 2.5%, half a point above the official inflation target rate.

And as in the U.S., a credit crunch is hurting businesses and consumers. Banks are reluctant to lend, though credit isn't out of reach for sound businesses. John Wyles, a partner with Gplus Europe, a consulting firm, says: "No one can tell whether we're through the worst of the credit crunch now or whether the worst is just around the corner and about to hit us in the face. I can't remember the last time there have been so many uncertainties."

We expect the European Central Bank (ECB) to raise interest rates next month and possibly one more time before year-end, despite the region's wobbly economies. Unlike the Federal Reserve and the Bank of England, which has ruled out a hike for now, the ECB's mandate is solely to fight inflation, not to boost growth as well.

The rate increases could bring the U.S. dollar below $1.60 to the euro once currency traders believe the Fed isn't rushing to raise interest rates in the U.S. But any moves will put pressure on the Federal Reserve to follow suit. That would bolster the dollar versus the euro and help reinvigorate flagging EU exports to the U.S. We think it will be very late in the year before the Fed starts pushing rates back up.

European demand for U.S. goods will stay strong, despite economic woes. With the weak dollar continuing to make U.S. goods and services very competitive, European companies and consumers see them as bargains. Especially popular: U.S. pharmaecuticals, oil and gas drilling equipment and U.S. fast-food outlets abroad. Also shopping expeditions to Fifth Avenue or Chicago's Miracle Mile and U.S. vacations. High-end stores and upscale hotels are benefiting most. "We had to buy an extra suitcase to bring everything home in," says a smiling recent visitor to the U.S.

Note that more Europeans are looking to the U.S. for private health care -- high quality at a lower price. One growth area: Second opinions by U.S. doctors. More and more foreign-based doctors, especially ones in Eastern Europe, are sending patient charts to colleagues in the U.S., seeking treatment alternatives.

Moreover, European investors aren't deterred by the weak U.S. economy. Belgian-based InBev's bid for Anheuser-Busch is a recent, high profile example. As Karl Sauvant, executive director of the Columbia Program on International Investment, explains: "Corporate strategies are typically strategies that go for several years and are not necessarily directly affected either by the exchange rate or by [an economic] downturn. If a company feels it has to be in the U.S. in the longer term, even if the current picture doesn't look good, it may be prompted to go in."

In fact, the strength of the euro may encourage more European manufacturers to offshore manufacturing to U.S. facilities, which could result in additional investment and job creation in the U.S. aerospace, automotive and machinery sectors.

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