Europe Economy Shrinks as Spending, Investment Falter

By Fergal O'Brien and Christian Vits

Aug. 14 (Bloomberg) -- Europe's economy contracted for the first time since the introduction of the euro almost a decade ago as faltering sales undermined investment by companies and soaring costs eroded consumer spending power.

Gross domestic product fell 0.2 percent in the second quarter from the first, when it increased 0.7 percent, the European Union statistics office in Luxembourg said today. The year-on-year growth rate slowed for a third straight quarter, to 1.5 percent. Separate figures showed inflation held at 4 percent in July, less than initially estimated.

The stronger euro and slower global growth have damped Europe's exports just as the fastest inflation in 16 years erodes domestic purchasing power. European Central Bank President Jean- Claude Trichet last week said growth will be ``particularly weak'' through the third quarter, and economists at UBS Ltd. and Unicredit MIB say the risk of a recession has increased.

``The buffer that separates the economy from outright recession has been largely exhausted,'' said Aurelio Maccario, chief euro-area economist at Unicredit in Milan. ``So a natural question is whether we have seen the worst, or if leading indicators have further to fall.''

For Sunil Kapadia, an economist at UBS in London, the probability of a recession, defined as two consecutive quarters of contraction, has risen ``probably to over 50 percent now'' from below 40 percent previously, he said today.

`A Bit Exaggerated'

``The signs are not really very good for the future,'' Amelia Torres, spokeswoman for EU Economic and Monetary Affairs Commissioner Joaquin Almunia, told journalists in Brussels today, though she deflected talk about a possible recession. ``It's a bit exaggerated to use that word.''

Even with the weaker growth, the central bank last month raised its key rate to 4.25 percent, a seven-year high, to curb price growth. While today's inflation reading was less than the 4.1 percent estimated earlier, it still is twice the ECB's 2 percent limit. Food-price increases accelerated to 6.7 percent in July, while energy-price inflation soared to 17.1 percent.

The slowdown isn't confined to the euro area. In the U.S., the world's largest economy, growth may average an annual 0.7 percent from July through December, half the pace of the first half. The Bank of England this week cut its forecast for U.K. expansion, Japan's economy is on the brink of a recession, and China today said industrial-output growth is at a 17-month low.

German GDP

In Europe, national data today showed German GDP fell a seasonally adjusted 0.5 percent from the first quarter, when it rose a revised 1.3 percent. The French and Italian economies also contracted in the April-June period, the Dutch economy stalled and Spain grew at the slowest pace since a 1993 recession as the nation's once-booming construction industry slumped.

Netherlands-based CSM NV, the world's largest supplier of ingredients to bakeries, yesterday said price increases will hurt U.S. sales and delayed a profitability goal. Ryanair Holdings Plc, Europe's biggest discount airline, may post the first full-year loss since going public in 1997.

``This is a cyclical downturn, which tends to be a long haul'' issue, said Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt. Nonetheless, the ECB ``needs more economic pain'' before it will lower interest rates, he said.

European two-year note yields rose 2 basis points to 4.03 percent after the GDP data. The yield on the German 10-year bund, Europe's benchmark government security, increased 1 basis point to 4.22 percent. The euro, which it has gained 10 percent in the last 12 months, was little changed at $1.4907 today.

Emerging Asia

Some companies are trying to offset falling western European and U.S. orders by expanding in eastern Europe, oil- exporting countries and emerging Asia. Hochtief AG, Germany's largest builder, today reported a jump in second-quarter profit and increased its full-year forecasts on rising demand for construction and mining work in Australia and Asia.

Hochtief rose 2.9 percent in Frankfurt trading. Europe's Dow Jones Stoxx 600 added 0.8 percent to 286.60 points.

Still, an index measuring the economic climate in the euro region dropped to a 15-year low, the Munich-based Ifo institute said yesterday, with measures of both current conditions and expectations declining. German factory orders have dropped for the past seven months.

While oil prices have retreated 20 percent from a record $147.27 a barrel reached on July 11, they are still 60 percent higher than a year ago.

``The real slowdown is only starting now,'' said David Kohl, deputy chief economist at Julius Baer Holding AG in Frankfurt. ``The worst is still ahead.''

To contact the reporters on this story: Fergal O'Brien in Dublin at fobrien@bloomberg.net; Christian Vits in Frankfurt at cvits@bloomberg.net.