Slowdown In Europe Bodes Ill

Slowing growth in Europe is a new market risk that can be added to the bevy of concerns weighing on American investors.

The dampening of economic growth in Europe is being driven by a lackluster American economy, a weakening euro, falling home prices in Britain, tightening credit conditions, and slowing European corporate profits. With some 8% of the total revenue of the S&P 500 index generated in Europe, a slowdown there almost certainly means a pullback for companies in America, according to a new report from Morgan Stanley.

"It's double trouble — Europe is joining the slowdown," the report, written by the chief U.S. investment strategist at Morgan Stanley, Abhijit Chakrabortti, and an analyst, Jason Todd, warns. "We believe the market is generally underestimating the potential decline in profits in Europe, including those for U.S. companies with European earnings exposure."

Although Europe saw strong growth in the first quarter, surveys of consumer confidence are showing some of their lowest levels in more than two years and consumer spending is plummeting, with retail sales dropping in March for the fourth time in six months.

Perhaps most significantly, the manufacturing sector, which had buoyed the European economy until recently, is starting to buckle. In April, a monthly survey of purchasing managers showed that the European manufacturing industry was operating at its slowest pace since August 2005. Meanwhile, two of Morgan Stanley's proprietary indicators suggest that European manufacturing may fall into a recession this quarter.

A softening European economy would lead to a depreciating euro, which would hurt those industries that have benefited from relatively inexpensive American goods. Even worse for these industries — which include companies in the materials, industrials, information technology, consumer discretionary, and health care sectors — a growing chorus of currency experts is predicting the dollar will emerge from the doldrums and strengthen during the next several months. This would further cut into American companies' profits, with a 10% appreciation in the dollar translating into as much as an 8% downswing in U.S. profit growth, according to the report, which was published Thursday.

"A European slowdown is something else to worry about," a money manager who manages nearly $100 million of assets at San Francisco-based Gary Wollin & Co., Gary Wollin, said. "A lot of big names here will feel the sales and earnings pain." This, he said, "could beat up some stocks."

Already, there is not much room for American companies to absorb a European slowdown — U.S. corporate profits declined 4% in the third quarter of 2007, 28% in the fourth quarter, and 15% in the first quarter of 2008, the report said.

According to Morgan Stanley, S&P 500 companies that manufacture and export materials represent 18% of European sales, and could be most hurt by weakness abroad. Industrials and information technology companies each account for 12% of sales; consumer discretionary makes up 11%, and health care 9%. Among the companies that could feel the pain: General Electric, United Technologies, Honeywell, and Boeing. Companies that depend on consumer discretionary spending, such as McDonald's, Ford Motor, Nike, and Black & Decker, may also feel the pinch. In the information technology space, Lexmark, Sun Microsystems, Juniper, and Hewlett-Packard could be hit.