Euro Zone Businesses Off To Bumper Start In Second Quarter

Gazing at the recent financial results of some of Europe’s prized companies you could easily jump to the conclusion that Europe is slowly grinding its way out of one of the most severe recessions in living memory. BMW, the German car maker first quarter results reported a net profit rise of 11 percent in the first quarter of 2014 on strong sales and the, Deutsche Lufthansa AG also reported a narrowing of its losses in the first quarter.  Moreover, just a few days ago the French global telecommunications company announced its first quarter results posting revenues of Euro 2,963 million, which equated to a 0.3 per cent increase in its profits. Inditex, the Spanish fashion giant reported also stronger sales and profits in the first quarter of 2014. Sales in the six weeks to March had increased by 12 per cent, according to a spokesperson from the company.

So, on the deck it appears that the 9.5 trillion euro economy has weathered the storm and the worst is now behind it. The recent released business climate index underscores this view, indicating that all remains stable at 0.39 in March, compared with 0.36 in February, according to a recent Reuters report.  A further poll of purchasing managers and retail sales data also indicates a further strengthening of the euro zones fragile recovery, as reported in the FT on March 6th. Indeed, the euro zone recovery is fragile and there maybe some storm clouds gathering. One main concern is that the growth in corporate profits in the euro zone is too heavily reliant on exports to emerging markets, rather than domestic consumption.  Take, for example the two companies above BMW and Index, they tend to typify the problem.  The bulk of BMW sales increases in its first quarter came from Asia a rise of 21 percent and sales to China rose by 25 percent, while sales in the euro zone remained sluggish.  Index, the Spanish clothing retailer also experienced a 5 percent increase in sales across its stores, but in Europe sales were actually down 0.5 per cent. 

Where will sales be generated when china’s economy starts slowing down, already economic indicates are suggesting that the Chinese economy is decelerating at a faster pace,  than what was previously thought, albeit still posting a growth 7.7 percent GDP in the final quarter of 2013. 

Despite the massive monetary economic expansion policy adopted by the European Central Bank (ECB) to stave off a depression following the 2008 financial meltdown unemployment, in parts of the Euro zone, particularly in the south remain at great depression levels. Incidentally, these miserably high levels of unemployment are exerting severe downward pressure on wages. It was recently reported that some workers in the Spanish southern province of Andalusia where accepting as little as three euros an hour. Meanwhile, if we factor into the equation the increases in the basic essential in energy costs and food stuffs it become blatantly apparent that real wages in the Euro zone are actually falling.  So with domestic consumption in the euro zone mashed and a looming slowdown in China’s economy where are the improving sales revenues going to come from in the second and third quarter for the euro zone companies?

The sluggish domestic demand has also got the ECB worried not about inflation, but actually deflation, falling prices.  The problem here is that when prices fall consumers have no incentive to buy, since why do so when sometime in the future the goods/services will be cheaper.  Businesses also have no incentive to invest. Deflation is a self-fulfilling vicious circle capable of bringing the economy to the brink.  No surprise then that deflation is also on the ECB’s radar.

If cost push inflation became an issue, caused by say a rise in energy, food cost, then an economic policy of raising interest rates could be adopted by the ECB to combat inflation. But doing so in a sluggish economic environment could be further headwinds for the fragile EU economic recovery.  Because higher interest rates would increase the costs of borrowing, increase the cost of financing debt and deter business investments-this is something the ECB would not want to do if it wants to stimulate the economy and create employment. 

The Euro zone is heavily depended on bank lending to finance consumer spending, business investment and employment. Despite this lending by euro-zone banks to the private sector fell 2.2% on the year in March, this followed a similar decline in the month before that in February. The rational for this new credit crunch is that the financial crisis of 2008 has burdened bank balance sheets with bad loans, which has diminished banks’ appetite to lend. ECB President Mario Draghi recently responded by saying that the problem of banks unwillingness to lend has, “motivated the ECB to launch new measures, later in the year, especially designed to encourage banks to lend to firms and households.”

It seems that the ECB is more concerned about consumer sending and business investment rather than deflation.  That could translate to more quantitative easing, purchasing of bonds to drive interest rates down. So the euro zone economy is not out of the woods yet. The high levels of unemployment, sluggish domestic consumption, the credit squeeze, the potential slow down in China and the geopolitical situation in Ukraine could all be a drag on future earnings and profits of companies in the Euro zone. With euro zone stock markets currently hovering around six year highs maybe the bulls have jumped the gun.