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Rating Action:

MOODY'S EUROPEAN CREDIT TRENDS - DAILY MARKET WRAP

01 Aug 2002
MOODY'S EUROPEAN CREDIT TRENDS - DAILY MARKET WRAP

London, 01 August 2002 -- - Eurozone Manufacturing is Stagnating Not Collapsing

- Baa-Spreads Widen as Number of Fallen Angels Increases

- UK Manufacturing Contracts for First Time in Six Months

EUROZONE MANUFACTURING IS STAGNATING NOT COLLAPSING

"While the performance of the Eurozone's manufacturing sector remains far from inspirational, the latest PMI points to a stagnation of activity rather than a collapse. Despite the euro's recent appreciation, global demand continued to fuel manufacturing growth. Moreover, it is important not to overstate the extent of the recent re-alignment of exchange rates, with the trade-weighted value of the euro still some 10% lower than its ten-year average and fragile."

- - - - - -

While the performance of the Eurozone's manufacturing sector remains far from inspirational, the latest PMI points to a stagnation of activity rather than a collapse. Overall activity in the sector expanded for the fourth consecutive month during July, albeit at a slightly slower pace than in June. Both the output and orders sub-indices were unchanged from the previous month. With economic growth idling, inflation subsiding and equity investors crying, today's decision by the European Central Bank (ECB) to leave interest rates on hold yielded few surprises.

Despite the euro's recent appreciation, global demand continued to fuel growth in the Eurozone's manufacturing sector during July. While annualised GDP growth in the US economy slipped from 2002 Q1's two-year high of 5.0% to just 1.1% during 2002 Q2, the data continues to point to a pause and not a downturn in the current recovery. Even though consumer confidence and the new orders of durable goods (-3.8% for June) both experienced precipitous drops, the housing market remains strong. Moreover, the increase in business spending during 2002 Q2, while small, was the first such increase since 2000 Q4. Perhaps more importantly for the Eurozone's manufacturing sector, however, US real imports increased at an annualised rate of 23.5% during 2002 Q2 - the fastest annualised increase since 1984 Q1 and notwithstanding an exchange rate less conducive to import demand.

The outlook for the Eurozone's exports clearly depends on the development of the global economy. While a stronger euro will raise the costs of Eurozone exports persuading some foreign consumers to substitute exports with cheaper domestically produced goods, a sustained recovery in global demand will mitigate the impact on the overall volume of trade. It is important not to overstate the extent of the recent re-alignment of exchange rates, with the trade-weighted value of the euro still some 10% lower than its ten-year average. Moreover, the 3.7% depreciation in the spot exchange rate from its peak reached in mid-July indicates that the fledgling euro currency still remains vulnerable to swings in investor sentiment.

Unlike in the US and UK, Eurozone consumers have not continued to spend throughout the current cyclical downturn. While unemployment has risen in the US, a flexible labour market provides households with some faith that companies will start hiring again as economic conditions improve. By contrast, although the overall level of unemployment in the Eurozone is still lower than during the mid-1990s, tight labour market regulations in some parts of the Eurozone continue to deter businesses from creating new jobs. The deflationary influence of a stronger exchange rate will eventually increase the purchasing power of Eurozone households - the impact of which should not be discounted given that around half of all Eurozone trade remains intra-regional. However, the dependence of Eurozone businesses on global demand to stimulate revenue growth will persist until further reforms promote a more liberal pace of job creation.

BAA-SPREADS WIDEN AS NUMBER OF FALLEN ANGELS INCREASES

Much has been made of the recent turmoil in global equity markets and the concurrent widening in corporate sector spreads. Indeed within Europe's corporate debt market, the average spread on euro-denominated investment-grade bonds with a five- to 11- year maturity widened by 12 basis points in July to their widest monthly average since December. However, while the average spread on Baa-rated bonds increased by 28 basis points during the month, the spread on Aa-rated bonds increased by a mere two basis points over the same period. Moreover, across the entire investment-grade spectrum, only the average yield on Baa-rated bonds rose during July.

Clearly investors have become more discerning. Telecoms and media companies have fallen from grace over the past two years. And while corporate Europe has not yet succumbed to the same level of accounting scandals as its counterpart across the Atlantic, fresh hints of scandals would undoubtedly threaten a further downturn in financial markets globally.

The recent widening in spreads at the lowest end of Europe's investment-grade spectrum may, however, also reflect an increase in the perceived rating migration risk of the existing pool of issuers - a trend that could have been exacerbated by an increase in fallen angel downgrades. During July, a further three Baa-rated issuers were downgraded from investment- to speculative-grade status, bringing the total number of so-called fallen angel downgrades in western Europe to six for 2002 to date. Over the decade ended 2001, on average, just three fallen angel downgrades were recorded per year in the region. However, it should also be noted that over the same period, the number of corporate issuers in Europe has increased fivefold. The six fallen angel downgrades recorded in 1992 accounted for 8.5% of the total number of investment-grade downgrades recorded in the region during the year. For the year to date, fallen angel downgrades comprise around 7% of all investment-grade downgrades announced in western Europe.

By Kerryn Fowlie

UK MANUFACTURING CONTRACTS FOR FIRST TIME IN SIX MONTHS

"House prices rose by 2.5% in the UK in June, contributing to an annual increase of 21.0% - the fastest annual growth in 13 years. The striking performance of the housing market was in stark contrast to the contraction revealed in manufacturing activity in July. The PMI index for UK manufacturing activity signalled that the manufacturing economy contracted in July for the first time in six months, with weakness in Eurozone demand adversely affecting the export performance of UK manufacturers."

- - - - - - -

House prices rose by 2.5% in the UK in June, contributing to an annual increase of 21.0% - the fastest annual growth in 13 years. Although down from a monthly growth rate of 3.3% in June, the change in July was still slightly above the average for the last six months. The rapid pace of house price growth does not seem to be letting up, buoyed by current high employment levels, a belief that lending rates will stay at their extremely low levels for a while to come and substitution away from equities. House prices and equity prices diverged in value in July, with the 2.5% increase in house prices softening somewhat the impact of the 10% fall in the value of equities. Some investors are turning to 'bricks and mortar' as an alternative to poorly performing equities, but the housing market is unlikely to remain immune to the detrimental effects of the equity price capitulation on consumer confidence.

The striking performance of the housing market is in stark contrast to the contraction revealed in manufacturing activity in July. The PMI index for UK manufacturing activity slipped from 50.6 in June, to a reading of 48.9 in July, according to the latest survey by the Chartered Institute of Purchasing and Supply. This result signalled that the UK manufacturing economy contracted in July, for the first time in six months.

Foreign order books were reported to have contracted in July, driven down by weak demand from the Eurozone. Trade with the Eurozone accounts for more than 50% of all UK exports. And persistently sluggish levels of domestic spending in the region have countered any potentially positive impact from the recent appreciation in the euro. For the three months ended May, UK exports increased by 7% relative to the previous three-month period. However, while exports to non-EU countries increased by 8.2% over the period, those to the Eurozone rose at a more modest pace of 5.8%. This point notwithstanding, firms operating in the US dollar market have already signalled the adverse effect of the stronger pound, which is likely to start showing up in UK export data over the months ahead.

Firms continued to cut employment as they sought to minimise costs by trimming excess capacity and stretch efficiency levels to increase productivity. Scepticism about sustainable recovery increased amongst panel firms, and the decision not to rush into expanding capacity seemed to be vindicated in July as firms reported a further month of employment cutbacks, in line with reduced overall demand for their products.

Margins were squeezed further as the growth in input price inflation accelerated to reach a one-and-a-half year high in July. The output price index contracted again in July, although the rate of contraction slowed somewhat, as firms struggled to attract new business.

As, expected, the Bank of England today decided to leave borrowing rates at their 38-year low of 4% today, amid signs of a faltering recovery.

By Alice Keegan

London
Kerryn Fowlie
Economist
Moody's Investor Services
Moody's Investors Service Ltd.
44 20 7772 5454

London
Alice Keegan
Statistical Economist
Moody's Investor Services
Moody's Investors Service Ltd.
44 20 7772 5454

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