Eurozone Forecast Autumn edition

The uncertainty continues. While progress in Europe has been made, we have not yet seen the market stability we all desire

With unemployment rising until 2014 and corporate investment to remain below its pre-crisis peak until 2016, business must learn to live with much greater volatility in the global economy than we have known in previous decades. And with the fragility of the global economy causing even rapid-growth economies to slow, the prospect of sustainable recovery remains a distant goal. As you will find in this edition of our forecast, full-blown quantitative easing is one potential solution.


But it’s not just about numbers. The 24-hour media cycle pumps out a relentless flow of data about high unemployment and stagnant growth rates, but lying behind those figures are stories of real people struggling with the challenge of making ends meet. In democratic Europe, these people are citizens with votes they can use to express their hopes and frustrations. As memories of the economic prosperity that underpinned the creation of the single currency recede, it’s incumbent on policymakers and business alike to search for the necessary answers and articulate them convincingly to a questioning electorate. So what’s the current state of play? GDP continues to stagnate, falling by 0.2% in Q2, and we continue to forecast a dip of about 0.5% for 2012 as a whole. Hard-pressed consumers have little cash to spare, and spending — already hit by high unemployment — remains limited by the ongoing squeeze on households. Even Germany, which has for so long been the powerhouse, is experiencing headwinds.

Despite its recent growth of 0.3% exceeding expectations, indicators suggest the volatility and uncertainty that have scarred the Eurozone could penetrate German borders. With companies still reluctant to unleash much-needed investment, the corporate world is faring little better. Leaving the corporate cash mountain untouched, however, prolongs the crisis. With the single currency continuing to be of huge benefit to businesses, the time has come for us to put our money where our interests lie.

However it’s not all bad news. The slowdown in emerging markets could well persuade investors to look favorably on local investments. The European Central Bank’s decision to start a vast bond purchase program has delivered a welcome boost. Policy-makers have also agreed to move toward European bank supervision and permit the European Stability Mechanism (ESM) to inject capital into banks directly. These are welcome developments, but we believe that more institutional reforms are required to deliver a lasting solution.

Although we remain optimistic that the closer banking and fiscal union necessary for the Eurozone’s long-term survival will materialize, the time has come for governments to be bold. Innovation is a key word for those with a growth agenda. This relates to areas such as new product development, process improvement and entrepreneurship Lessons from other parts of the world show that there are measures to take to support all these areas, and thereby create jobs and growth. As we see in our research, governments’ ability to support entrepreneurial activity is key to increasing productivity. Investments are being made in Europe, but Europe is behind other parts of the world in creating the right environment for entrepreneurship to thrive.

But it’s not only up to policy-makers to achieve change. Corporates that manage to adapt to the situation will also find the opportunities to thrive and contribute to growth. They can do this by overhauling their strategic thinking, by serving consumers differently, by managing diverse risks, by coping with austerity in the public sector and, not least, by identifying and targeting opportunities and sectors that will enable them to outperform. Some five years after the start of the financial crisis, recovery is not assured. That much is certain. But the journey toward deeper integration — and with it a more prosperous future — has started. It’s time to pick up the pace.


For economies and companies, uncertainty has become an exhausting enemy. A prolonged slowdown will compound business risks. Already, companies exposed to the euro, and especially the peripheral economies, seek to protect themselves from sudden shocks. They struggle to deal with shifting demand in once-familiar markets. And against a swirling backdrop, they are preparing for a future business environment that will present different challenges and opportunities from those seen in the past.

A shifting outlook: Germany slows and the Eurozone slides

Vanguard companies are resetting their course to navigate deeper currents of rapid change, modified customer behavior and a prolonged period of slow economic growth. That seems wise. For we expect only gradual progress toward the deeper economic integration required to cure the euro’s woes. Combine this with austerity measures and credit constraints, and we expect slow policy progress to contribute to a further downturn in economic conditions during the second half of the year. Although Germany and France performed better than expected, Eurozone gross domestic product (GDP) fell 0.2% in the second quarter, after a standstill in the fi rst. We continue to forecast a 0.5% contraction during 2012 as a whole.

The overall trend concealed substantial variation between countries. The Eurozone is no longer a homogenous bloc, but a northern core with a fragmented southern periphery. The German economy grew by 0.3% in the second quarter compared with the first. It beat expectations, but the pace of expansion in Germany — regarded as the engine of growth for the Eurozone economy — slowed from 0.5% in the first quarter.

France too avoided a widely-anticipated contraction, treading water for a third successive quarter. The Netherlands and Austria each achieved growth of 0.2%. But quarter-on-quarter output fell in Italy by 0.7%, by 0.4% in Spain and by 1.0% in Finland, previously a firm member of the “northern club.” In Greece, the pain remains all too evident: the economy contracted 6.2% year-on-year, continuing a downtrend that has now lasted for more than four years. The pattern in the second quarter was therefore one of slowing or stalled growth in the Eurozone core, and continuing contraction on the periphery, triggering an overall retrenchment.




Soft demand: deterring corporate Investment

Understanding what is happening, where and why is vital for businesses striving to adapt. Across the Eurozone as a whole, consumer spending will remain under pressure from high and rising unemployment in many countries. Consumers are breaking into two camps: the “haves,” with a job and cash to spare, and the “have-nots,” who count every euro they spend. Corporate investment, in the meantime, is being held back by uncertainty over the future of the single currency, sluggish earnings and high funding costs in many countries, plus weak demand in many sectors. De-stocking is likely to accentuate the downturn, as companies seek to clear the increase in inventories that has already built up.

In theory, the weakness of the euro should help exports and encourage import substitution, even as imports ease in response to soft demand. Until recently, many companies exporting beyond the Eurozone continued to prosper. Germany’s economic resilience stemmed from competitive costs and from exporting a large proportion of output. But now many export markets in the US, China and emerging economies are weakening, alongside those in the Eurozone. The Ifo Business Climate Index for Germany recorded a fourth monthly fall in August, with export expectations turning slightly negative.

Germany may escape recession, if it is lucky. For companies in most Eurozone countries, however, there seems little prospect of any rapid recovery in overall demand. Deleveraging has much further to go in the Eurozone. Falling demand from governments will hit consumers and companies, perhaps triggering a spiral of retrenchment. Looking further ahead, a reduction in consumer spending due to the number of baby boomers reaching retirement will in turn suppress growth.


The near-term prospect of a breakup of the Eurozone appears to have receded. Mario Draghi, Governor of the European Central Bank (ECB), has calmed markets with a promise to buy the bonds of any countries in the 17-nation bloc that get into trouble, depressing yields in Spain and Italy. But companies, and those who invest in them, have no grounds for complacency. Though the prospect of imminent disaster has receded, so too has the prospect of a Eurozone economic recovery.

We foresee economic expansion of just 0.1% in 2013 for the Eurozone as a whole. Recovery may follow in 2014, but if so it is likely to remain very anemic. The best hope is that structural changes in peripheral countries will start to bear fruit and result in lower unemployment and a gradual return of confidence.

We believe that companies are becoming reconciled to low growth in the coming 18 months, but have yet to integrate the possibility of a slowdown lasting for the next two to three years.

Adapting to thrive: overhauling strategic thinking

Companies now need to anticipate the consequences of a prolonged slowdown. They need to reassess the demand outlook in national markets within the Eurozone and evaluate how it affects their corporate prospects. What is the right strategic allocation of resources to, and within, the Eurozone in the light of its changing prospects compared with other regions, where growth may also be slowing?

Is a change of business model required? Is the business or asset portfolio appropriate? Asset valuations remain high: if assets are to be sold, will write-downs be required? If the objective is in fact consolidation to bolster market share, what valuations are appropriate? Strategic directions should reflect long-term prospects. Business plans and budgets should embrace the realities of financing … and risk.

Adapting to thrive: serving consumers differently

Retail and consumer goods companies in the Eurozone are adapting to a burgeoning population of cash-strapped consumers. According to Eurostat, 18 million Eurozone workers lack jobs. The unemployment rate of 11.3% shows a widening gap between the Eurozone and EU as a whole, where the rate is 10.4%. Worst hit is Spain, with 25% of workers unemployed, followed by Greece at 23%. Yet in Austria the unemployment rate is only 4.5%, and in the Netherlands just 5.3%.

But consumer-facing companies are simultaneously wrestling with the effects on consumption patterns of mobile computing and an aging population in an era of accelerating change. Many companies need to speed up efforts to adapt the products they offer, and the way they deliver them.

Around two-thirds of Eurozone consumers now do their shopping on a tighter budget than before. For daily needs, they stick to a shopping list and buy smaller quantities closer to home, paying careful attention to price. The “haves” with job security or healthy incomes may still fi ll a trolley at the hypermarket, yet may now favor own-brands, or order online. For bigger ticket items, both the “haves” and the “have-nots” can scan goods in-store, compare prices and buy where they are cheapest — increasingly on the internet.

Retailers are therefore experimenting with different formats. Own-label products fi ght for space (in smaller, more convenient stores) with fewer, more dominant brands. Mid-priced brands and products are being squeezed out.



Preparing the future

Astute consumer products companies are mimicking strategies learned in emerging markets, developing or repackaging products to hit price points that suit smaller spenders, whether families or retirees — especially in southern Europe. Detergents may sell in packs of 5 washes instead of 50. Six-packs are giving way to single cans.

Rather than sacrifice market share, the best branded product companies are resetting their prices at lower price points and striving to retain customers through innovation. To sustain margins, they must focus on continuous operational improvement, harvesting benefits derived from simpler, cheaper packaging and other cost savings.

Looking ahead, successful retailers will be those who anticipate rather than trail shifting consumer needs. Many supermarket chains now have convenient, wide-aisle stores with friendly service catering to the elderly. For the time-pressed they are complementing online ordering with scan-and-shop displays at commuter stations, backed by home delivery or drive-by pickups.

As brands battle for consumer loyalty and the internet becomes central to the purchasing decision, wherever it is made, developing effective dialogue via social media will be essential. And so will the ability to sell online.

In the meantime, with food commodity prices on a long-term upswing, forward-looking manufacturers will seek to secure supply, while bracing for tough battles ahead with retail clients who are reluctant to pass on higher prices to financially stressed Eurozone consumers.

Adapting to thrive: coping with austerity in the public sector

Austerity is having a big impact on public sector markets, especially in southern Europe. When national or regional governments run out of cash, they often trim purchases and delay payments to suppliers, especially for recurrent expenditure on health care or education, which accounts for a large part of Eurozone public spending.

In health care, the effect on pharmaceutical companies is severe. The European Federation of Pharmaceutical Industries and Associations (EFPIA) has estimated that European states owe €12–€15 billion to the pharmaceutical industry.2 In addition, Sir Andrew Witty, EFPIA President, wrote in June that “in just five countries (Greece, Ireland, Italy, Portugal and Spain) the pharmaceutical industry has contributed, through price cuts and discounts, more than €7 billion for the years 2010 and 2011.” According to him, the price cuts equaled more than 8% of annual industry turnover in these markets.

Suppliers of drugs, medical consumables and energy to health care organizations feel obliged to maintain supply despite payment arrears because refusal could put lives at stake. But even multinationals serving global markets feel the effects of payment delays and price cuts on such a scale. One effect, Sir Andrew warned, was to undermine incentives for innovation and push investment to countries where research and development are welcomed. A second was to promote re-exportation of pharmaceutical products from low-price to higher priced countries.

Smaller, local suppliers of goods and services may be still more dependent on troubled public sector clients and have little opportunity to develop complementary private sector markets. They can face severe liquidity problems as a result of cuts in public procurement or payment delays. Reported austerity impacts range from reduced purchases in Catalonia’s state schools to the sale of real estate and postponement of infrastructure projects.

Selling property in depressed markets can drive down prices. Delaying building new hospitals, clinics, schools and bridges compounds the difficulties of a Eurozone construction industry already suffering from a sharp fall in private sector demand.

Managing risk: liquidity, leverage and finance

For companies, financial and operational challenges are intensifying. A year ago, many blue chips were enjoying strong revenue and profit performances from activities in, or exports to, emerging markets. As growth softens in Asia and Latin America, that cushion provides less insulation from troubles in the Eurozone. Today revenues, margins and profits are being squeezed, making companies more vulnerable to external risks. These may include non-payment by customers, or the collapse of a supplier. The logical response is to reinforce liquidity.

A renewed credit crunch remains possible, however, and fi nuancing conditions are tightening. Many of Europe’s banks are still wrestling with the aftermath of the financial crisis, including consolidation or divestment, restructuring and dealing with portfolios of underperforming loans. They are simultaneously seeking to strengthen their balance sheets to meet tougher capital requirements. Banks’ ability to lend is being constrained.

According to a survey by the ECB, on balance 10% of Eurozone banks tightened lending criteria for companies in the second quarter, and 10% were expected to do so in the third. In July, Eurozone banks said demand for loans from enterprises fell 25% in the second quarter, and would fall again in the third. The biggest reason was a steep fall in companies’ need to finance fixed investment.

Though companies are finding it harder to borrow from banks, the issue draws limited attention because, with demand slack, companies have less need to borrow. But sooner or later companies will need more working capital to expand output, or to invest in expanding or modernizing capacity.

European companies are behaving cautiously. Some are deleveraging. Others are reinforcing their liquidity by raising extra funds. Many European blue chips are taking advantage of market strength to swap short-term debt for longer-term bonds, often at lower interest rates. During the fi rst half of 2012, bond issuance by European companies matched the value of syndicated loans from banks, with French corporates leading the way. In bond markets, respected companies can often borrow more cheaply than banks.

Small - and medium-sized enterprises (SMEs), which often rely heavily on banks for their funding, cannot easily access capital markets. Prudent managers of small companies will now begin building relationships with alternative lenders. New options are emerging. In one recent development, larger companies with ready access to finance at affordable rates have made loans to smaller key suppliers. Meanwhile some asset managers have set up loan funds to fi ll the gap left by banks, and this source has the potential for growth.

Managing risk: operating in a fragmented Eurozone

Companies are realizing that they should no longer treat the Eurozone as a homogenous bloc. Northern Europe has low interest rates and an undervalued exchange rate; southern Europe has an overvalued currency and interest rates that are too high. For companies, this creates risk.

Managing risks arising from mismatches between borrowings and assets is an urgent priority. Companies should establish where and in what currency their assets are denominated, and how they could be affected if the country quits the euro.

Some companies are seeking to match local assets and liabilities. One solution is to borrow against assets in high-risk countries, perhaps repatriating cash as an exceptional dividend.

Treasury operations merit close attention. Companies are increasingly striving to maximize liquidity and minimize the amount of cash kept in “at-risk” markets. Solutions may include frequent cash sweeps to withdraw surplus funds from countries where there is a perceived risk of a euro exit. However, resulting receivables in the peripheral country could lead to a taxable currency gain if the country quits the euro: sweeps should be followed by dividend distributions.

Similarly, redenomination of a currency could lead to windfall profits on inventory held in a peripheral country if the new currency depreciates, incurring a tax liability. Supply chain, inventory and related tax issues are coming to the fore. Companies must ask:

- Are business conditions within the Eurozone endangering any of my suppliers? If so, how should I respond?

- Should I develop in-country supply chains in Eurozone countries?

-  Should I try to recreate a vertically integrated supply chain?

- Should inventory be owned where currency devaluation is possible, or elsewhere?




Finding the best solutions to customers’ needs

Today, within the Eurozone’s single market, we see a striking diversity of demand patterns and operating environments. Companies are learning to assess and react to risk — country by country. Astute financial and corporate investors from outside the EU have learned and are applying this lesson, buying loan portfolios and assets in a targeted way.

Companies must now join them in overhauling their long-term Eurozone strategies. They need to adjust to the prospect of a sustained regional downturn, with a slow and anemic recovery, when it comes. They must awaken to country risks. And they need to identify and target opportunities and sectors that will enable them to outperform.

Uncertainty over the future of the euro has tested the Eurozone economy to the limit. Demand has changed in scale, location and nature. Tough times lie ahead. But Europeans, and the companies that serve them, are here to stay. Companies that fi nd the best solutions to the new and future needs of their customers will ultimately win. That ground rule for business success, at least, remains unchanged.

German companies stay on track as economy slows

Though Germany’s growth is slowing, the corporate sector of what is widely regarded as the “motor” economy of Europe has proved more resilient than widely expected. Mid-market companies with revenues of €500 million to €2.5 billion are the backbone of the German economy. In the last downturn, many saw sales slide by 30% to 50%. But today, though margins are under pressure and some have reported lower profi ts, they are better equipped to weather the softening of demand that is undoubtedly under way.

Such companies became lean and fit through cost reduction programs, reshaping their supply chains, and enhancing their flexibility and agility. Today, most are continuing both research and development and capital investment.

Generally, companies with strong exposure to emerging markets, such as Germany’s automotive champions, are also proving resilient. The exceptions lie in non-cyclical sectors that were spared restructuring pressure in the last downturn but now face structural issues, notably in power generation, pharmaceuticals and retail.

Power companies need to find new sources of revenue to replace nuclear plants threatened with closure and diminished margins on energy trading. Pharmaceutical company margins, in the meantime, are under pressure from increased competition. They must decide whether to focus on more individualized treatments, or instead use their distribution power to become more like consumer products companies, leaving more nimble innovators to develop the drugs of the future. Today these sectors are belatedly cutting costs and seeking efficiencies.

So are some mid-sized retailers that rely mainly on Germany’s domestic market. But overall there are few signs that companies are cutting capital spending or economizing on the professional services that they need to continue business development.

Privatization: sell-offs can spur Investment

Strategies to resolve the debt crisis in the southern Eurozone draw upon many lessons from the Latin American debt crisis of the 1980s, where the International Monetary Fund (IMF) also required government austerity packages and market liberalization in exchange for bailouts. In Latin America, some governments also used debt for equity schemes to encourage inward investment and a recovery of investor confidence.

In southern Europe, encouraged by the IMF, privatization schemes are part of the drive to enhance competitiveness. These are often overlooked, yet Greece, Spain, Portugal and Ireland have all launched substantial programs to sell state assets.

Such programs typically include the sale of utilities supplying electricity, gas and water; operators of airports, ports and railways; and interests in businesses ranging from airlines, telecoms and lotteries to postal distribution.

Shifting activities like these into the private sector can bring about fundamental changes in their relationship with the state. Strong, independent and fair-minded regulators must be set up to ensure the impartial promotion of competition and to underpin the confidence of investors. If this can be achieved, companies run by private sector managers may be more focused on customer service and cost control, especially if they are also subject to increased competition. Sell-offs can also spur investment by new owners, whether these are national or international companies.

Ireland and Portugal have made good progress with disposals. Spain is reportedly drafting a substantial program despite opposition from trade unions. And in Greece, where earlier plans stalled, Prime Minister Antonis Samaras in August promised a privatization program that would exceed expectations.

According to reports8 Greece aims to raise €19 billion between 2012 and 2015. Alongside infrastructure facilities, state assets scheduled to be offered for sale include beach-front development sites, a shopping mall and broadcasting center, and a license to run the state lottery.

Assets such as these can be attractive to both fi nancial investors and specialist utility companies around the world. However, the Greek disposal program is hindered by excessive bureaucracy, the perceived risk that Greece could leave the euro and uncertainty over future demand levels in the economy. Looking beyond uncertainty in an era of rapid change.



The long and winding road to a more federal Europe

European policy-makers made some small but important steps forward during the summer, with an agreement to move toward European bank supervision and allow the ESM to inject capital into banks directly. The ECB announcement of a bond purchase plan has also contributed to a considerable easing of strains in financial markets. These reforms had been identified in our previous forecast as necessary, but not sufficient, to restore stability to the region. On their own, however, these three measures still fall short of the deep institutional reforms that we have for some time argued are necessary to deliver a lasting solution to the crisis.

We remain confident that the crisis will eventually push governments into adopting the bold solutions required to prevent a breakup of the single currency area. But it is likely that such progress will continue to be made in a piecemeal fashion rather than with any sudden breakthrough. The result is that lingering policy uncertainty will continue to cloud the economic environment and fuel renewed bouts of financial market volatility over the coming year. As the peripheral economies gradually regain their competitiveness and the region’s economy rebalances, however, signs of recover should become apparent from 2014.




The Eurozone faces many headwinds …

After remaining flat in Q1 2012, economic activity in the Eurozone resumed its decline in Q2 with an estimated 0.2% contraction in GDP. The data continued to paint a predictable picture of resilience in Germany and a few other core Eurozone countries, and ongoing deep recession in southern Europe. But more recent sentiment indicators suggest that the German growth engine may also be starting to succumb to the crisis, with a gloomier tone overall from many companies regarding their earnings and sales expectations. Indeed, it is likely that economic conditions in the Eurozone as a whole will deteriorate further in the next few months, as the region bows in the face of multiple headwinds.

One major factor holding back activity in many economies in the region is the ongoing fi scal adjustment. Several Eurozone governments, notably those in the periphery, have announced additional fiscal tightening for 2012 over the last few months, which will weigh further on growth. In total, we estimate that Eurozone governments are introducing spending cuts and tax rises equivalent to more than 1% of GDP in both 2012 and 2013, which will reduce output in the Eurozone by over 1% over this period. The precise effect of this fiscal tightening on the economy is uncertain, however. This reflects not only a lack of clarity regarding the size of fiscal multipliers in each country, but also the potential for negative effects to be amplified in economies already mired in recession. The fact that a coordinated fiscal tightening is still being implemented by so many member states also raises the potential for additional negative spillover effects between economies. Risks are therefore skewed to the downside.

Tight credit conditions represent a second headwind buffeting the economy. Encouragingly, the July 2012 Bank Lending Survey from the ECB showed that net tightening of banks’ credit conditions remained broadly stable in Q2 compared with the previous quarter, for loans to both non-financial corporations and households. In particular, the net tightening in Q2 2012 was much lower than in Q4 2011, despite the intensification of the sovereign debt crisis. This stabilization probably reflects the continued positive impact of the ECB’s long-term refinancing operations (LTROs) on the funding positions of banks. Although the risk of an outright credit crunch in the Eurozone appears to have receded, credit is still difficult to access, which will restrict spending by businesses and consumers.

The global economic climate has also darkened in the past few months. This development has already been flagged by relatively weak releases of key indicators in both advanced and emerging economies in the past couple of months. To the extent that the external environment has cooled, this will dampen prospects for further export-led growth in the Eurozone this year.

Finally, compounding the negative impact from these headwinds is the heightened level of uncertainty regarding the future direction of economic policy in the Eurozone. Uncertainty