The impact of even dramatically slower growth in Europe would only trim US growth fractionally; Asia is far more important for the US outlook (see Global Economics: Asian Amplification, February 4, 2010). However, the European sovereign crisis does create a tail risk for US growth and markets: If the crisis spills over into broader risk-aversion and a drying up of liquidity - the functional equivalent of the US subprime crisis - the consequences could be more dire. At the least, these unknown risks make us more cautious about risky assets (see Sovereign Crisis Roadmap, February 11, 2010).
Challenge to sustainable growth. Strong growth abroad is one of four pillars for our view that the US economy is at the start of sustainable growth through 2011 (the other three: improving financial conditions, persistent impact from fiscal stimulus, and the elimination of excesses (see Outlook 2010: Higher Rates, Fed Exit and Sustainable Growth, January 4, 2010). Thus, a slowdown in Europe's economies would at least challenge that thesis.
Indeed, from a short-to-medium-term cyclical perspective, the crisis seems likely to slow European growth through three channels: 1) rising risk premiums on the region's sovereign debt will tighten financial conditions; 2) higher funding costs and constraints on market access will limit the supply of bank credit; and 3) fiscal tightening - both spending cuts and tax increases - will weigh on growth in peripheral economies. In turn, the willingness of core EU countries to backstop the periphery, perhaps with an emergency lending facility sponsored by Germany, seems likely to cause the contagion to spread to the core. As a result, we now expect 10-year Bund yields, which have begun to rise despite soft incoming European data, to rise to 4.5% this year. A weaker euro will be a partial offset by helping boost the region's export competitiveness; we expect the euro to decline to 1.24 EUR/USD.
Quantifying the fallout for the US. We estimate that a one-percentage-point slowdown in European growth might shave 0.2% from that in the US. Three channels matter: exports, earnings and financial linkages.
Exports: Big share, but slow growth. Exports of goods and services to the European Union account for 29% of the US total, but given our outlook for tepid EU growth, the contribution to US growth from European demand is small. Nonetheless, a dramatic slowdown in European demand would dent US export growth. In contrast, Asia ex Japan is growing eight times faster than the EU, and Canada and Latin America are growing four times faster. The share of US exports of goods and services to Asia (27%) is comparable to the EU, while Canada and Latin America account for 37%. We see upside risks to both those sources of export vigor.
Earnings/Income: An important, overlooked channel. US income from direct investment is much more closely coupled to Europe, because Europe accounts for 57% of the US$3.1 trillion in overseas facilities owned by US companies. So, a slowdown in European growth will affect results at US affiliates in the region, which contribute roughly one-sixth of US earnings. Slower growth in Europe would slice 200-300bp from the likely rise in US earnings this year. Fortunately, the growth differentials matter; while Asia accounts for only 20% of direct investment income, its rapid growth is contributing a like amount to US earnings growth.
Financial linkages to Europe: More diffuse and hard to calibrate, but could be noticeable. A rise in core European sovereign yields could intensify concerns about the sustainability of US fiscal policy among global investors and push up US Treasury yields. Uncertainty about the slowdown in Europe might weigh on US credit and equity prices. Slower growth in Europe would depress results at US global financial services firms and could make them more hesitant to lend. US financial exposure to Europe is relatively low: For example, US banks' claims on residents of the European periphery were a miniscule 0.3% of total assets as of 3Q09, and claims on all European residents amounted to only to 4.6% of total assets (see Betsy Graseck's Quick Comment: International Exposure a Low Risk for US Banks, February 10, 2010). As we learned in the financial crisis, however, such linkages could be the most important of all if idiosyncratic risk morphs into something systemic. Indeed, while the retreat in risky assets in the past few weeks is not yet a headwind for growth, it is hardly a plus (for credit implications, see Problematic Relatives - Downgrading € IG Credit, February 12, 2010).
Cross checking. To cross-check these results, we estimated a Vector Auto Regression among three variables: Growth in US GDP, US domestic demand, and overseas GDP. Shocking the system with an impulse response shows that a 1pp change in the growth of foreign GDP will move US GDP growth by 60% of that, which is consistent with our back-of-the-envelope calculation of a 0.2% impact from a similar change in Europe alone.
Contagion tail risk. Our base case is that peripheral Europe will muddle through with assistance from the core. Yet the crisis will surely slow European growth somewhat. Contagion spreading from the European banking system is the biggest tail risk. If the crisis spills over into broader risk-aversion, a drying up of liquidity, and deleveraging - the functional equivalent of the US subprime crisis - the consequences could be more dire. That scenario is far from investors' minds, and we think it is highly unlikely, given that EU officials have made it clear that conditional assistance for Greece is coming. But that's what makes it important to think about.
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