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Focus on Europe rates as economy slows

By Jeremy Gaunt, European Investment Correspondent Reuters - Sunday, May 4 04:11 pm

LONDON (Reuters) - Europe will be a major focus of investors' attention this week as the European Central Bank and Bank of England meet separately to discuss interest rates against a backdrop of declining economic strength.

With global equity markets rallying and worries about the credit crisis easing, signs that U.S. economic woes are contagious could easily dent tentative investor optimism.

Global stocks as measured by MSCI gained 5.31 percent in April. Perhaps surprisingly, this was the largest monthly gain since December 2003.

Investors also unwound safe-haven plays, lifting yields and knocking investment bank Citi's world government bond returns index down 1.15 percent for the month. Gold is also at a four-month low.

But the tentativeness of this new risk appetite is clear from Reuters polls showing that although major investment houses across the world increased exposure to equities in April, they clung to above-average cash reserves.

Hanging on to cash is what professional investors do when they are uncertain about the future.

Much of the uncertainty swirls around the fate of the ailing U.S. economy. But worries that the U.S. downturn is spreading are also growing.

"There is little doubt that we will see contagion," said Klaus Wiener, head of research at Italy's Generali Investments, adding that it was already under way in Europe.

In its twice-yearly economic forecasts last week, the European Commission cut its growth projection for the 15 countries that use the euro, saying the economy would slow to 1.7 percent this year and 1.5 percent in 2009 from 2.6 percent in 2007.

Various data releases have also been poor, including Friday's RBS/NTC Purchasing Managers Index for the euro zone manufacturing sector which fell to 50.7 in April, its slowest pace in nearly three years.

Business morale in powerhouse Germany is also at its weakest since January 2006, according to the Munich-based Ifo economic research institute.

French consumer confidence, meanwhile, is at a more than 10 year low and Spanish retail sales are down sharply.

RATE RUMBLINGS

With this in mind, investors will be closely scrutinising the ECB's meeting on Thursday, no so much for an actual movement in rates but for signs of whether economic decline is beginning to concern the policymakers.

The bank, which is firmly focused on inflation risk, is widely expected to leave rates unchanged at 4.0 percent.

But analysts in a Reuters poll forecast that the slowing economy will force two 25 basis point cuts in the second half of the year, taking the main rate to 3.50 percent by December.

The language used by ECB President Jean-Claude Trichet in a news conference after the decision will show whether recent inflationary pressures such as crude oil's rise to nearly $120 a barrel are putting back a likely cut or whether economic worries are bringing one forward.

Any change in tone should be most immediately noticeable on foreign exchange markets, where the euro is at around one and a half month-lows against the dollar, which has been boosted by an expected pause in interest rate easing by the U.S. Federal Reserve.

"There is a risk (to expectations) that they will tone down the rhetoric," said Mitul Kotecha, head of global foreign exchange research at Calyon. "It could see more momentum loss from the euro."

The Bank of England, meanwhile, is also expected to hold off on cutting interest rates from 5.0 percent this week as it battles to control high inflation.

But many economists expect a move to 4.75 percent in June

Britain's economy grew at its weakest rate in three years in the first quarter at only 0.4 percent, below the long-term trend.

EQUITIES RALLY

As for equities, this would traditionally be the time that investors pack up for the summer, following the market adage "Sell in May and Go Away".

This time investors have barely started buying and are still some way off moving into positive territory for the year-to-date, let alone recovering to pre-credit crunch levels.

The question before investors is whether April's rally and its extension into early March is part of a longer-term recovery or simple a bear market rally.

Generali's Wiener believes it is the latter. In a note to clients his firm recommended that they take profits from the recent rally, which it sees petering out this month.

One key will be earnings.

Most of the Wall Street heavyweights have already reported and with 78 percent of the S&P 500 in, Thomson Reuters calculates that around 63 percent have surprised with better-than-expected results versus 26 percent that have disappointed.

Europe, however, still has some bellwether reports to come, including this week Swiss Re , UBS , France Telecom , Lafarge , Commerzbank and British American Tobacco .

By contrast with the S&P 500, Thomson Reuters data suggests only 52 percent of the 105 European STOXX 600 that have reported have come in above expectations, compared with 46 percent that have missed.