The Western European business environment is beginning to feel like another case of déjà vu: bond yields are rising, putting pressure on sovereign borrowing costs; budget deficits are missing targets, endangering market stability; and growth is lower than expected, meaning that governments will raise less revenue and companies will miss their regional targets as well. In a year that began with strong production and high expectations, what went wrong?
It feels like déjà vu because we have seen this before
First, this trend is not new. Forecasts have a consistent track record of downward revisions under current economic conditions, and eurozone GDP forecasts in particular have been reduced throughout the crisis.
These sharp adjustments in expectations are challenging corporate plans again this year. One year ago, the IMF expected that the euro area would grow by 1.5% YOY and the EU would grow 1.7%. The Fund’s latest World Economic Outlook has categorically reduced forecasts, bringing euro area growth to 0.9% YOY (-0.6%) and the EU to 1.1% (also -0.6%). Similarly optimistic expectations for inflation have been tempered throughout 2014:
The point is not to call out that forecasts are often wrong. Revision is a necessary aspect of casting a crystal ball into the economic future. However, for MNCs that use these forecasts to consider their 2015 targets, an aggressive case of managing expectations despite these forecasts may be in order.
It’s not simply a result of the Ukraine crisis
Decelerating growth expectations in Europe are not the result of one-off political risks that put downward pressure on economic activity. Instead, the structural misalignment of Eurozone economies will continue to render the region vulnerable to whatever change in the wind that comes along. As a result, relatively small events could have a disproportionately large impact on already-fragile eurozone growth.
The key factor that has the potential to support business in Europe – credit – will disappoint next year as banks take additional steps to clean up their balance sheets when stress test results are released. As 85% of European businesses, most of which are SMEs, rely on bank financing for any new capital, they once more will be unable to invest in new capacity or hire extra workers.
In addition to the low and contracting supply of fresh capital to fuel the business environment, demand will remain low. General elections in the UK, which may force a referendum to leave the EU; Spain, which is facing secessionist pressure from Catalonia; and a possible early election in Greece, which could topple the country’s chances of leaving its bailout, will all obscure the business environment throughout the year. As sovereign bond yields rise, reversing the trend of yield compression that has been taking place since 2012, the perception of investment risk will rise as well. If governments stick to austerity, then businesses will continue to shut down due to higher borrowing costs with no support for additional funding. If highly indebted countries with looming political risk try to borrow to spend, they could be shut out of capital markets without direct ECB support.
As a result, very few businesses will be taking risks in this environment. Employment will improve more slowly than anticipated, and growth, once again, will disappoint.
Expect that forecasts for 2015 will be revised down
In 2015, businesses in Europe will face a new flavor of the same dilemma they have seen before, and companies should carefully manage expectations for growth in the region. Spurts of growth are misleading, as regional organizations update technology and replace furniture that they have not been able to replace in the six years since the crisis began. Companies should be prepared to see monthly data that looks optimistic at points as companies rebuild inventories, but the ultimate result will be another year of overall weak growth. Until lending improves, and businesses feel that they can take advantage of it, companies should only expect another year of muddling along.