What is the biggest economic event for Europe right now? The obvious answer is the surge in the euro's value against the dollar. But there is another, much less visible trend that, in the long run, could trump the currency story: the clear emergence of two Europes -- that part of the European economy driven by Europe's multinationals and the Europe bogged down in an endless struggle to reform and grow. How much further this split develops could have huge consequences for the region.
Europe's gross domestic product grew an estimated 1.8% in 2004 and won't do any better in 2005. In contrast, Europe's best companies have revved up profits by shifting ever more jobs abroad, streamlining plants at home, and focusing on emerging markets and the U.S. In the process, they are certainly taking some hits from the euro's strength, which affects exports, and from subpar growth at home. But, overall, the top companies are surprisingly robust. For example, Siemens' (SI) net income rose 39% to $4.6 billion in the fiscal year ended Sept. 30, thanks in part to strong foreign sales. Munich-based HVB Group expects the German giant's earnings to climb another 12% in 2005.
The earnings trend is starkest in Germany, where corporate profits as a share of national income are at all-time highs. Yet "the fact of the matter is most of these excellent results have very little to do with Germany," says Hans-Olaf Henkel, former president of the German Federation of Industry. German Retailer Metro has seen domestic sales stagnate, while sales in Eastern Europe soared 18% in the latest quarter. The trend is Europewide. A survey by Morgan Stanley (MWD) found that 42% of European companies reported third-quarter earnings above expectations or near an all-time high, vs. only 6% that disappointed. Even though Europe seems permanently on the skids, the big German and French stock indices are up more than 7% this year. A broader European index, the Dow Jones STOXX 600 is up 9.5%, ahead of the Standard & Poor's 500.
Europe's big companies have been investing outside the region for years, of course. But the trend has accelerated sharply, for several reasons. The strong euro increasingly is encouraging the best companies to manufacture abroad both to cut costs and to hedge against currency fluctuations. The recent expansion of the European Union to include much of Eastern Europe has created a natural zone for low-tax, low-wage operations. Perhaps most important, the big companies are quietly giving up on the idea that reforms will deregulate Western Europe's rigid labor market and ease taxes deeply enough and fast enough to help them. They "don't have the patience to wait for the politicians," says Ralph Wiechers, chief economist of the German Engineering Federation. "They're creating their own facts." One example: Continental (CTTAY), Germany's big tire and auto parts maker. The company hasn't deserted Germany, but new production capacity is heavily concentrated overseas. Since July, Continental has opened a factory in Romania, started another in Brazil, and inked deals in Slovakia and China.
You'd think this decoupling would provoke a backlash. There have certainly been protests. Berthold Huber, deputy chairman of Germany's militant IG Metall union, recently accused managers of "speaking with a forked tongue" when they record big profits "yet in the same breath demand that employees forsake pay raises." What's interesting, though, is not how hot the rhetoric is, but how relatively muted the actions of unions and policymakers have been. While railing publicly against capitalism, IG Metall leaders recently inked deals at Siemens and Volkswagen in which workers made concessions on pay and hours in return for job security. Labor leaders "see the facts and figures, and they know what's happening," says Siegmar Mosdorf, a former deputy secretary in the German Economics Ministry during Chancellor Gerhard Schr?der's first term. Maybe the two Europes will still find a way to help each other. For now, the best companies are determined to do what it takes to survive and thrive. The other Europe can follow -- or get left behind.
By Jack Ewing