At a time when rising interest rates in the U.S. are seen curtailing economic growth going forward, some signs indicated that the recovery in Japan and the European market, or euro zone, could offset some of the weakness in the U.S. Hopes of such an outcome are now likely to be dashed.
MITIGATING EXPORTS. While leading growth indicators in the euro zone still look positive, investors shouldn't expect the member economies to shoulder the responsibility of maintaining the momentum in the world economy. Prior to the news out of Japan, the International Monetary Fund was projecting global growth to expand by 4.4% next year.
Japanese economic growth in the second quarter was already expected to trail its 5.3% annualized rate recorded in the first quarter. Looking forward -- and with an election looming -- investors can expect a downward revision to growth forecasts.
Some of this, however, could be mitigated by Japanese exports, which would be fueled by the further weakening of the yen, which is already down 10% against the dollar year-to-date.
LESS OPTIMISTIC PICTURE. Investors in Europe have snapped up equities in recent months on expectations that the global economy was in better shape than forecast earlier this year. The collapse of the Koizumi government will likely shake that confidence.
A slowdown in Japan inevitably would hit Chinese exports, already under modest pressure following the yuan's revaluation. When this is combined with the projected cooling in the U.S. economy in 2006, the picture that emerges isn't as bright as the one many optimists had painted in recent weeks.
As trading volumes dip in Europe in the coming weeks, investors' confidence will likely be severely tested. While big moves are unlikely, we expect the more volatile (high beta) sectors to suffer, as a recovery in the euro will hit currency-sensitive sectors, such as pharmaceuticals. McDonnell is European equity strategist for Standard & Poor's