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Economic Forecasts

U.S. Can Survive a European Recession

A downturn in Europe will cut U.S. exports and raise credit costs, but won’t have a big impact.

Europe is slipping into recession, with contraction likely in the fourth quarter and through the first half of 2012.

The economic slowdown is being caused by the lingering sovereign debt crisis in Ireland, Portugal, Greece and now Italy. The predicament is slowing trade among euro member states, fueling austerity sentiment, decreasing government spending and discouraging business investment. Expect the European Union to grow just 0.4% in 2012, following 1.2% growth this year.

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The U.S. economy will feel the impact of this slowdown, but isn’t likely to slide back into recession — unless Europe spins out of control and experiences a default of a major economy, which we don’t expect. Look for the U.S. to hang on to a lean 2% growth in 2012 gross domestic product, about the same pace as in 2011.

We’re in for at least six more months of uncertainty in financial markets, as Europe struggles to put itself right. Don’t expect business leaders to commit to new hiring until there’s a clearer path for global economic growth. But the U.S. is seeing strength in essential areas. Business spending is expected to be up 5% next year, while consumer sales will grow by as much as 10%. Interest rates will stay low for the foreseeable future, and inflation is expected fall in 2012. Even with weak housing and slow growth in jobs, we don’t expect a U.S. recession.

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Still, a recession in Europe would impact some areas of the U.S. economy more than others. Specifically, expect a decline in European demand for U.S. exports. Europe buys about one-fifth of American exports. Some U.S. states will be hit harder by an export decline, according to a recent survey by Wells Fargo Securities.

Utah, South Carolina, Louisiana and West Virginia earn the largest portions of their state GDP from European exports, and could be harder-hit than other states by declining export activity. Producers of construction and farm machinery, food, aircraft, high-tech gear and other U.S.-manufactured goods will all experience less growth in Europe. Overall, though, the drop in U.S. exports will reduce GDP by just 0.1 percentage points in 2012.

International interest rates are on the rise — a sign of increased stress in bank-to-bank lending. Though still low, the one-year London Interbank Offered Rate is up 20 basis points since June. LIBOR is widely employed as a benchmark rate in the U.S., mostly on adjustable rate mortgages and about half of private student loans, as it fluctuates more than the Fed-based prime rate. Higher rates mean consumers pay more for loans and will be less likely to borrow.

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The biggest risk, of course, is a new financial crisis spurred by government debt that causes a cascade of bank failures around the world. Greece is already insolvent and while U.S. bank exposure to Greek debt is limited, most big American banks have stakes in European banks, which are facing big write-downs for Greece. Plus, U.S. banks hold $47 billion in Italian bonds, which could be at risk for similar losses.

Odds are Italy won’t default on its debt and trigger a cascade of failures. The bold moves needed to jolt the country’s stagnant economy back to life are coming, but won’t happen quickly. Italy’s leaders must push through strong measures to boost growth, which averaged just 0.25% annually over the past decade. The country will try to cut bureaucratic red tape to improve its business climate — it currently ranks 87th in the world in terms of ease of doing business, according to the World Bank.

Italian leaders also need to push for long-term, structural labor reforms and to sell public assets to shore up reserves. Such measures are needed to calm investors’ nerves and stop the rise of bond yields, which are hovering above 6% of late. At that level, Italy will have trouble rolling over $273 billion in debt coming due by the end of April.

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