Europe's renaissance

The last four years have been excellent for the global economy. Output has increased faster than at any time since the early 1970s while inflation pressures have remained subdued. As a result, equity markets have been able to deliver strong returns.

Weaker output growth in the US, largely as a result of a collapse in activity in the housing market, has raised concerns that this favourable environment may be coming to an end. However, the rest of the world continues to grow at a healthy pace and looks to be doing enough to compensate for weakness in the US. Strong output growth in China - and indeed in the rest of Asia - no longer surprises. What is less expected, but all the more welcome for that, is the improvement over the last couple of years in the performance of Europe.

In the euro-area, real GDP (the total output of the economy) increased by 2.7% a year over the five years to 2000. Growth then slowed to half this pace, 1.4%, over the next five years. So it was a pleasant surprise when Europe's growth accelerated again in 2006, reaching 2.8%.

Two developments appear to be behind this resurgence in European growth. The first is a revival in domestic spending. Strong profits and rising rates of capacity utilisation have triggered a pick-up in investment spending and surveys suggest businesses plan further increases in future. At the same time, companies are also planning to increase their workforces. This is leading to higher employment and stronger growth in household incomes, which in turn has boosted consumer spending.

The second development is increased exports to Eastern Europe and Asia. European companies seem to have been very successful in targeting markets in the fastest growing regions of the globe. To some observers, what is even more remarkable than the improvement in the European economy is the fact that Germany, long regarded as the ‘sick man' of Europe, is at the forefront of its renaissance. Over the year to the final quarter of 2006 the euroarea expanded by 3.3%; Germany by 3.7%. And leading indicators and confidence measures suggest that growth in Germany remained strong in the early part of 2007. Unemployment has fallen below 4 million and is at its lowest level for more than four years.

Several years of structural reform are beginning to pay dividends in Germany. After the introduction of the euro, German companies had to aggressively control costs in order to improve their competitiveness. This came at the price of falling employment and moderate growth in household incomes and spending. But companies have been so successful in improving competitiveness they have increased their share in global markets to the point where Germany is now the world's largest exporters of goods. The wider economy is reaping the benefits in terms of increased employment and spending. This is good news for the rest of Europe, and for countries like the UK that do a lot of trade with Germany. It has also been good news for investors in European equity markets. Over the last two years (to the end of April), the Dow Jones Euro Stoxx index, a closelywatched measure of stock market performance in the euro-area, increased at an annual rate of 26%, exactly twice the 13% gain recorded by the US S&P 500 index. (The Germany DAX index rose by 33% a year over the same period.)

There are some downsides. As the evidence suggesting output growth in Europe is likely to be sustained has increased, the European Central Bank (ECB) has felt able to increase interest rates from 2% to 3¾%, so far. This has pushed up longer-term yields too, resulting in poor returns for investors in bonds.

Higher interest rates across Europe have also helped to boost the euro's exchange rate, from below $1.20 when the ECB first raised rates in December 2005 to $1.36 now. This has been a mixed blessing. The stronger euro will have made it harder for Europe's exporters to compete in world markets. But it has also had the effect of moderating recent rises in oil and other commodity prices, which are priced in US dollars (the oil price is up 16% since the end of 2005 in US dollars, but unchanged in euros over the same period), so moderating inflation pressures.

Overall, though, there is no doubt this renaissance in Europe is good news for the global economy. Fortunately, it looks set to continue in the short-term. Recent surveys suggest household and business confidence is high, so growth in consumption and investment spending should be sustained. Looking further out much will depend on inflation pressures and the ECB. If inflation pressures remain muted and the ECB does not raise interest rates too far, then Europe's renaissance might well be sustained into 2008.

Tony Dolphin, Director of Economics and Asset Allocation, Henderson Global Investors