What’s ailing Europe?

Posted by Scriptaty | 8:31 PM

There are only two things that ail Europe: economics and politics. Throughout the first part of 2005, economists lowered their Euro-zone growth forecasts for this year. Near the middle of the second quarter, the European Central Bank cut its 2005 GDP forecast from 1.8 to 1.6 percent, which is still slightly above the consensus forecast of investment banks as identified by The Economist magazine (May 14).

The market had been anticipating an ECB rate hike in the second half of the year, but the disappointing growth outlook has prompted a change of thought. As reflected in the Euribor futures strip, the market now expects the ECB to stand pat throughout 2005.

That said, further weakness in the Euro might encourage speculation the ECB will hike rates on ideas the Euro’s strength helped keep inflation in check and partially offset the rise in oil and other commodity prices. Euro-zone inflation is expected to be a modest 1.8 to 2.0 percent in 2005.

Given this macroeconomic picture and the shift in interest rate differentials, it is hardly surprising a Merrill Lynch survey in mid-May found the Euro was the most over-valued currency.

The outlook for UK interest rates was subject to a greater swing in expectations. Many market participants had thought there would be one more interest rate hike in the current tightening cycle. And such expectations helped underpin the pound in the early part of the year.

However, soft retail sales data continued cooling in the once red-hot housing market, and weak survey data has pushed the market sentiment pendulum toward discounting a rate cut by year-end. The risk is the market might be getting a bit ahead of itself. Political considerations are also judged by many to be a negative for the Euro; the key issue being the referendums on the EU Constitution. Some countries have already approved the EU Constitution, but the adoption requires unanimity. Any country’s rejection would stop the process cold.

The immediate focus is on France, which will hold its referendum a few days before this analysis is published in early June. Currently the polls are very close, but they suggest the “non” camp might enjoy a slim lead. Recall that France gave the (in)famous “petite oui” to the Euro. A few days after the French referendum, the Dutch will hold theirs; a “yes” vote there is not a done deal, either.

However, perhaps in an ideal world, France, the Netherlands, and some of the Euro-skeptics like Denmark would approve the Constitution to force a showdown with the UK.

The Euro is five years old and polls still suggest nearly two-thirds of Britain is opposed to adopting the single currency. Given this sentiment and the loss of support for the Labour Party reflected in May’s national election, it does not appear Prime Minister Tony Blair has the political capital to ensure the UK will approve the EU Constitution.

A Frenchman or a Dutch woman can safely vote for the Constitution, preventing their country from being blamed for derailing the process and feel fairly confident the British will deal a coup de grace in early 2006. It is possible Blair will have to invest so much political capital behind what seems to be a doomed proposition that he will step down shortly afterward.

That said, the odds-on favorite scenario is that both France and the Netherlands reject the Constitution.