Uncertainty is the dominant theme for the European growth outlook in 2008. The spike in oil prices coincided with the continued financial market turmoil, and the combination of the two threatens to restrain growth across Europe. This is especially so in the UK where the fallout from the credit market turmoil has already fed through to a tightening of monetary conditions which, if it persists, will be inappropriate for the current pace of growth.
A likely slowdown in world trade growth, as the US economy weakens, also poses risks to the export outlook, despite the ongoing strength of emerging markets. As a result, 2008 GDP growth forecasts have been trimmed to 1.6 per cent for the eurozone and 1.5 per cent for the UK.
The near-term inflation risks in the eurozone are very much on the upside and will make the ECB much more reluctant than the Bank of England to respond with rate cuts during 2008. The Bank of England's Monetary Policy Committee is expected to continue cutting rates in the early part of this year, taking the bank rate down to 4.5 per cent by end-2008. The ECB is also expected to continue to pursue other options to ease the money market tensions. An ECB rate cut is not expected until the second quarter of 2008.
Five months into the financial market turmoil and the outlook for Europe has, if anything, become even more uncertain. Three of the world's major central banks have already cut policy rates, billions of dollars, euros, pounds (and other currencies) have been injected and yet money market rates, at least of three-month maturity, remain extraordinarily elevated.
Technical factors such as year-end effects are playing a role but it is becoming increasingly apparent they do not provide the full explanation.
Even if spreads continue to subside over the next few weeks, they may move back up again during the first quarter of this year as fears emerge over what may be revealed when banks announce their full-year results in late February and early March.
Banks may simply continue to hoard liquidity in the coming months as counterparty risk rises in line with the underlying deterioration in asset
quality.
Central bank action is expected to ensure that the worst of the money market tensions have passed but do not expect a full return to "normality", hence the assumption that three-month money rates in the major economies will remain at a 20-30 basis points premium even by the end of 2008.
Clearly, trying to quantify the impact on the real economy of such a move in rates is very hard, particularly as the lags with which such developments in money-market rates and changes in lending standards feed through can be unpredictable. Settling into 2008, the main vulnerability in Europe is the UK's heavily indebted household sector. Consumer spending has been boosted by persistent increases in house prices, inflated expectations of more to come and a loosening of mortgage lending practices, all of which are now moving into reverse. This is likely to result in a marked slowdown in residential investment, a rise in household savings rates and a slowdown in consumer spending.
For the eurozone, the outlook is a little more upbeat but still highly uncertain. Clearly, parts of the EMU, notably Germany and Austria, should continue to benefit from the ongoing investment boom in emerging markets. However, should the recent turmoil feed through into a more prolonged developed-world credit squeeze, the eurozone is vulnerable both through the external hit from slower growth in its two biggest export markets - the US and UK - as well as tighter bank lending standards domestically.
In the eurozone, the risk from any prolonged credit squeeze relates more to the corporate sector rather than the household sector. However, based on the latest bank lending data, there is very little evidence so far of a eurozone credit squeeze in the monetary data.
This may partly reflect re-intermediation, as capital markets have become less accessible, and the fact that the financial turmoil is still a relatively recent development.
The slowdown in investment envisaged in 2008 is also a response to the fact that eurozone capacity utilisation is no longer rising, together with changes in German taxation from this month that encouraged a front-loading of investment in 2006-07. This should dampen equipment investment activity. However, given recent overinvestment and its sensitivity to higher interest rates, housing construction appears set to slow more markedly than machinery and equipment. This would be in line with recent signs of softer housing markets across the eurozone.
The eurozone household sector's relatively lower indebtedness makes consumer spending less vulnerable than it is in the UK to a reduced availability of credit.
Also, unlike corporate loan growth, households in the eurozone have already responded to the monetary tightening by slowing their borrowing markedly since early 2006. The cost of servicing mortgages, however, continues to rise in the likes of Italy and Spain, where the majority of mortgages are at variable rates. This is both as a consequence of the lagged impact of past ECB rate increases and of higher money-market rates feeding through into higher spreads.
Probably the bigger risk to eurozone consumer spending is from the ongoing squeeze in real wages from the persistent increases in food and energy prices over the past year. This should partly reverse as inflation subsides but employment growth is already showing signs of slowing and this could intensify if a sustained credit squeeze exacerbates the housing slowdown.
It appears 2008 is going to be a difficult year for economic growth.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
A likely slowdown in world trade growth, as the US economy weakens, also poses risks to the export outlook, despite the ongoing strength of emerging markets. As a result, 2008 GDP growth forecasts have been trimmed to 1.6 per cent for the eurozone and 1.5 per cent for the UK.
The near-term inflation risks in the eurozone are very much on the upside and will make the ECB much more reluctant than the Bank of England to respond with rate cuts during 2008. The Bank of England's Monetary Policy Committee is expected to continue cutting rates in the early part of this year, taking the bank rate down to 4.5 per cent by end-2008. The ECB is also expected to continue to pursue other options to ease the money market tensions. An ECB rate cut is not expected until the second quarter of 2008.
Five months into the financial market turmoil and the outlook for Europe has, if anything, become even more uncertain. Three of the world's major central banks have already cut policy rates, billions of dollars, euros, pounds (and other currencies) have been injected and yet money market rates, at least of three-month maturity, remain extraordinarily elevated.
Technical factors such as year-end effects are playing a role but it is becoming increasingly apparent they do not provide the full explanation.
Even if spreads continue to subside over the next few weeks, they may move back up again during the first quarter of this year as fears emerge over what may be revealed when banks announce their full-year results in late February and early March.
Banks may simply continue to hoard liquidity in the coming months as counterparty risk rises in line with the underlying deterioration in asset
quality.
Central bank action is expected to ensure that the worst of the money market tensions have passed but do not expect a full return to "normality", hence the assumption that three-month money rates in the major economies will remain at a 20-30 basis points premium even by the end of 2008.
Clearly, trying to quantify the impact on the real economy of such a move in rates is very hard, particularly as the lags with which such developments in money-market rates and changes in lending standards feed through can be unpredictable. Settling into 2008, the main vulnerability in Europe is the UK's heavily indebted household sector. Consumer spending has been boosted by persistent increases in house prices, inflated expectations of more to come and a loosening of mortgage lending practices, all of which are now moving into reverse. This is likely to result in a marked slowdown in residential investment, a rise in household savings rates and a slowdown in consumer spending.
For the eurozone, the outlook is a little more upbeat but still highly uncertain. Clearly, parts of the EMU, notably Germany and Austria, should continue to benefit from the ongoing investment boom in emerging markets. However, should the recent turmoil feed through into a more prolonged developed-world credit squeeze, the eurozone is vulnerable both through the external hit from slower growth in its two biggest export markets - the US and UK - as well as tighter bank lending standards domestically.
In the eurozone, the risk from any prolonged credit squeeze relates more to the corporate sector rather than the household sector. However, based on the latest bank lending data, there is very little evidence so far of a eurozone credit squeeze in the monetary data.
This may partly reflect re-intermediation, as capital markets have become less accessible, and the fact that the financial turmoil is still a relatively recent development.
The slowdown in investment envisaged in 2008 is also a response to the fact that eurozone capacity utilisation is no longer rising, together with changes in German taxation from this month that encouraged a front-loading of investment in 2006-07. This should dampen equipment investment activity. However, given recent overinvestment and its sensitivity to higher interest rates, housing construction appears set to slow more markedly than machinery and equipment. This would be in line with recent signs of softer housing markets across the eurozone.
The eurozone household sector's relatively lower indebtedness makes consumer spending less vulnerable than it is in the UK to a reduced availability of credit.
Also, unlike corporate loan growth, households in the eurozone have already responded to the monetary tightening by slowing their borrowing markedly since early 2006. The cost of servicing mortgages, however, continues to rise in the likes of Italy and Spain, where the majority of mortgages are at variable rates. This is both as a consequence of the lagged impact of past ECB rate increases and of higher money-market rates feeding through into higher spreads.
Probably the bigger risk to eurozone consumer spending is from the ongoing squeeze in real wages from the persistent increases in food and energy prices over the past year. This should partly reverse as inflation subsides but employment growth is already showing signs of slowing and this could intensify if a sustained credit squeeze exacerbates the housing slowdown.
It appears 2008 is going to be a difficult year for economic growth.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.