EU economic growth is steady -- Use to lessen risk

December 27, 2006

The EU economy is forecast to grow at a steady 2.7% in 2007, down slightly from this year’s 2.9% growth, according to December’s “Financial Stability Review” published by the European Central Bank (ECB). This assumes no financial shocks, (described below) which could cause the 2007 GDP growth rate to be only 1.7% in 2007, and 1.8% in 2008.

The European Central Bank warned that a Value-Added Tax (VAT) increase that Germany will levy in January will drag down the rest of the European economy by raising prices, and slowing trade, of imports into Germany, Europe’s largest economy. Germany must increase taxes to balance its budget as mandated by its membership in the European Union.

What the ECB report on the EU economy means:
The good news is that the ECB does not expect a large decline in growth, as seen in the U.S., and that the U.S. decline will not affect Europe as much thanks to lower European exports to the U.S.

However, the ECB does warn of several events that could seriously disrupt the European economy:

• If the ECB raises interest rates too quickly, it could absorb much of the market liquidity that has provided a buffer for financial shocks.
• The U.S. current account deficit which makes the U.S. economy dependent on continued “loans”, via Treasury bond purchases, from Asian and oil-producing countries.
• Disruptive swings in the stock or commodities markets caused by hedge funds, the extent of whose investments are unknown.
• Oil price shocks, which could cause a stock market panic in the short term, leading to bankruptcy of hedge funds and other highly leveraged financial institutions that had been counting on a continued good global economy. This could then lead to higher long-term interest rates, potentially depleting reserves of these institutions.

Action steps:
Make sure you have a good allocation of European mutual funds in your retirement portfolio. Stay alert to the traumatic events warned of by the ECB, and be prepared to rebalance your portfolio should any of those events occur.

Source: European Central Bank, “Financial Stability Review”, December 8, 2006.