Reality check for Europe

Reality check for Europe

By Mike Dolan Sun Feb 10, 10:04 AM ET

LONDON, Feb 10 - (Reuters) - The extent of Europe's infection from the U.S. subprime mortgage virus is becoming clearer, even as the European Central Bank faces down calls for it to follow U.S. and UK counterparts by cutting interest rates.

Early estimates of fourth-quarter national output from the big euro zone economies are due later this week. The picture is probably one of growth in the 15-nation currency area marginally outstripping the U.S. economy in the final quarter of last year.

But there are growing signs the credit crisis and looming U.S. recession have hit Europe deeper than policymakers seem willing to acknowledge. Hopes that the euro zone can remain partly insulated from a U.S. housing bust and recession are receding.

Cisco Systems (CSCO.O), the largest maker of the routers and switches that direct traffic on data networks, warned last week of a rapid slowdown in both U.S. and European orders.

Significantly, the Cisco numbers suggested conditions were deteriorating faster in Europe than the United States. In the quarter through January order growth in Europe more than halved to 8 percent. U.S. order growth slipped only one percentage point to 12 percent.

"It's the most cautious I've seen CEOs in the U.S. and Europe in many years," Cisco Chief Executive John Chambers said.

That tallied with last week's shock service sector surveys. Any suggestion that Europe was weathering a U.S.-focused downturn seemed wide of the mark.

While attention largely centered on a plunge in confidence among U.S. service firms in January, German, Spanish and Italian service sectors also recorded their first contraction in years.

Financial markets are waking up also to the idea that it may be dangerous to use the relatively robust ECB economic forecasts as anything other than an interest rate pointer.

"The market is becoming aware that the crisis in the United States will indeed have an adverse impact on growth in Europe," said Heino Ruland, strategist at FrankfurtFinanz in Germany.

Pan-European stock markets have had one of their worst January performances on record and entered bear market territory in the course of that month. The FTSEurofirst (.FTEU3) lost another four percent this week.

"We now see a deterioration in the euro area," said Luca Paolini, strategist at Credit Suisse. "If anything the risks are higher in the euro area than in the U.S. -- where expectations are already very low. And you still don't have a policy response from the ECB."

ECB President Jean-Claude Trichet acknowledged the darkening economic horizon after the bank left interest rates unchanged again at 4 percent on Thursday even as the Bank of England cut its key rates again by a quarter of a percentage point.

"If I take all the data, they confirm risks lie to the downside," Trichet told a news conference

Yet few expect an ECB rate cut for at least another month as the central bank focuses on above-target inflation rates instead. The combination of rising concern and a lack of action is worrying for many. The U.S. Federal Reserve has slashed its key interest rates by 2-1/4 percentage points in five months.

The reaction reminds many economists of ECB arguments in 2001 that the U.S. dot.com bubble burst would have less of an impact on euro zone households than those in the United States.

Back then, the ECB first cut rates some four months after the Fed started easing and cumulatively in 2001 the U.S. central bank's rate cuts were three times those of the ECB.

"It's one of the reasons the euro zone economy is always lagging. The ECB is looking at inflation -- which is in itself a lagging economic indicator in -- and the Fed looks more towards underlying growth," said Paolini at Credit Suisse.

FLASH FORECASTS

Any undershoot of fourth-quarter gross domestic product data next week would merely reinforce the point and heap further pressure on the ECB to look beyond near-term inflation rates.

Estimates for Germany, France, Spain and the overall euro zone are due for release on Thursday. Median forecasts for the single currency area are for growth to more than halve to 0.3 percent from 0.8 percent in the third quarter of the year.

That's still about twice the rate recorded in the United States in the final three months of 2007 but the difference is little more than a margin of error given how prone GDP data is to big revisions.

If, as many suspect, subsequent revisions show the U.S. may even have contracted during the final quarter then it may well be in the middle of recession already. Two consecutive quarters of GDP contraction is how most economists define one.

Further soundings on sentiment will be evident before Thursday and these are not likely to be pretty either.

On Tuesday, the German ZEW index of investor confidence in February is due for release and, as it disproportionately reflects the mood in the financial world, it is widely expected to fall sharply.

"As the risks to economic growth build, Europe's central banks will likely be even more inclined to lean against the coming downturn," Deutsche Bank economists said in a note to clients on Friday. "We now expect the ECB to cut rates 100bp by the end of this year, starting in Q2."