By Simon Kennedy

Aug. 3 (Bloomberg) — Dwindling profits, slowing investment and the highest unemployment in a decade risk damping Europe?s recovery from the worst recession in six decades, even as signs of a rebound emerge.

The euro area?s potential growth rate will fall by half next year to 0.6 percent, according to estimates by the Organization for Economic Cooperation and Development. The pace of expansion at which inflation accelerates may be the slowest since records began in 1991 and below the 1.3 percent anticipated for the U.S.

The decline may further swell the biggest government budget deficits since the euro began trading in 1999 and constrain earnings at companies including German chemical maker BASF SE. It will also buoy government bonds of the biggest European economies, which have lagged behind stocks so far this year, according to BlackRock Inc. and Pacific Investment Management Co., the world?s biggest bond manager.

?The underlying economic trends are pretty questionable in Europe,? said Scott Thiel, head of European fixed income in London at BlackRock, the largest publicly traded U.S. asset- management firm. He favors buying longer-dated debt of countries such as Germany over securities of smaller, more indebted nations such as Spain and Greece.

?The Europeans will be slower to emerge from the crisis,? said Thiel, whose firm oversees $1.37 trillion.

The economy of the 16 nations that use the euro will contract by 4.8 percent this year and 0.3 percent in 2010, compared with a decline in the U.S. of 2.6 percent in 2009 and growth of 0.8 percent next year, according to estimates by the Washington-based International Monetary Fund.

Slower Expansion

Europe?s slower expansion will restrain stocks as companies struggle to increase earnings, said Andrew Balls, head of the European investment team in London for Pimco, a unit of Munich- based insurer Allianz SE. Bonds will gain as sluggish growth and the European Central Bank keep inflation in check, Balls said, even as governments issue a record amount of debt.

Europe may feel more pain than the U.S. because greater government regulation means its potential growth rate was already lower, said Marco Annunziata, chief economist at UniCredit Group, a provider of financial products and services, in London. If the Paris-based OECD?s forecasts prove correct, Royal Bank of Scotland Group Plc calculates the output of euro- area countries will be 800 billion euros ($1.14 trillion) lower by the end of 2015 than the 2008 trend suggested.

Record Low

The long-term potential rate for Europe will slide to 1.3 percent from 2 percent before the crisis, while the U.S. pace will fall to a record low of 2.5 percent from about 3.25 percent, Annunziata said.

The decrease will limit Europe?s capacity to grow without inflation, even as evidence builds that the economy is stabilizing. The European Commission reported July 30 that confidence in the economic outlook increased more than forecast in July, with an index of executive and consumer sentiment rising to 76, the highest since November, from 73.2 in June.

?Even in a worst-case situation, the U.S.?s potential will be greater than Europe?s,? Annunziata said.

A survey of 1,076 Bloomberg subscribers released July 22 showed 44 percent of respondents said the European continent poses the greatest investment risk, more than double the percentage citing the U.S.

European bonds are beating Treasuries for the first time in four years. German government debt returned 0.9 percent this year, compared with a 4.1 percent loss for U.S. debt, according to Bloomberg/EFFAS indexes. While the Dow Jones Euro Stoxx 50 Index last week reached its highest since November, stock investors are paying 12.5 times estimated profits, compared with 14.5 for the Dow Jones Industrial Average in the U.S.

More Muted

Europe?s banking and housing crises were more muted than in the U.S., said Eric Chaney, chief economist at insurance and financial-service company AXA Group in Paris. Lenders in the Americas have had credit losses and writedowns totaling $1 trillion, compared with $470 billion for those in Europe, based on data compiled by Bloomberg.

The euro area will grow next year by 2.1 percent, according to estimates by David Mackie, head of Western European economic research at JPMorgan Chase & Co. He raised his forecast from 1.7 percent, betting that global trade will rebound.

If the potential growth rate is as low as the OECD estimates next year, there is a ?distinct possibility? the Frankfurt-based ECB will begin raising interest rates, even if expansion is still weak, because of concern that the economy is more prone to inflation than before the crisis, Annunziata said.

Emergency Loans

Europe?s potential growth rate ?is likely to be lower than in the past,? said central-bank Vice President Lucas Papademos in an interview with Germany?s Handelsblatt newspaper published July 29. This complicates the timing of the bank?s decision to reverse the emergency loans and rate cuts it introduced to spur the economy, he said.

That may be the reason policy makers aren?t willing to ?undertake the last margins of monetary easing? and trim the benchmark rate below a record 1 percent as other Group of Seven central banks have done, said Julian Callow, chief European economist at Barclays Capital in London. The governing council next meets Aug. 6.

Governments may have to borrow more to pay the bill for a weaker expansion. Even if lawmakers curb spending, lower potential growth could propel debt beyond 100 percent of gross domestic product in France within three years and in Germany in 2017, according to economists at HSBC Holdings Plc in London. The Brussels-based European Commission estimates German debt will be 73.4 percent of GDP this year, while French debt will be 79.7 percent.

Rising Deficits

More debt and rising budget deficits mean European bonds may still suffer, said Andre de Silva, HSBC?s global deputy head of fixed-income strategy. He predicts sales of government debt in the euro region will rise to a record 950 billion euros in 2010 from 870 billion euros this year.

Companies are reducing the economy?s productive capacity as they seek to protect earnings by curbing investment in plants, staff and research, said Kevin Gaynor, chief markets economist at RBS in London.

BASF, based in Ludwigshafen, Germany, said it expects a ?significant? drop in sales and profit this year after shutting factories to weather sliding demand. After cutting jobs and output, the firm reported July 30 that net income fell 74 percent to 343 million euros in the second quarter.

?Bottomed Out?

?The downturn seems to have bottomed out, and there seems to be stabilization at a low level,? Kurt Bock, the company?s chief financial officer, said in a statement. ?But we see no signs of a sustained upturn.?

Air France-KLM Group, Europe?s biggest airline, and competitors including British Airways Plc are reorganizing as they face reduced demand and plunging sales. The Paris-based carrier reported a net loss of 431 million euros for the three months ended June 30. Analysts had predicted a loss of 194 million euros, based on the median of five estimates compiled by Bloomberg.

Omega Pharma NV, Belgium?s biggest supplier of pharmacy products, fell 4.8 percent to 1.11 euros on July 17, the most in almost three months in Brussels trading, after reporting the day before a steeper-than-estimated drop in second-quarter sales. The company abandoned its forecast for a ?slight? increase for the full year.

Investment and hiring may also be constrained because European nonfinancial companies have bigger debts than their U.S. peers.

96 Percent

European corporate debt at the end of 2008 was equivalent to 96 percent of GDP, compared with 50 percent in the U.S., according to Gilles Moec, an economist at Deutsche Bank AG in London.

?The recovery in investment will be more subdued because of the debt overhang,? Moec said.

Companies also may accelerate job cuts, further pressuring the economy, said Colin Ellis, economist at Daiwa Securities SMBC Europe Ltd. in London. Europe?s unemployment rate has risen 2.2 percentage points to a decade-high of 9.4 percent since the March 2008 low of 7.2 percent, according to data from Eurostat, the European Union?s statistics office. In the same period, the U.S. rate has jumped 4.4 percentage points to 9.5 percent, the highest since August 1983.

Munich-based Siemens AG, Europe?s largest engineering company, said July 22 it plans to chop an additional 1,400 jobs from its 409,000 workforce to help meet profit targets. It already announced 17,000 cuts a year ago and put 19,000 employees on reduced hours.

?Noticeable Reluctance?

?In our incoming orders, we detect a noticeable reluctance among our customers,? said Siemens?s CFO, Joe Kaeser.

Slow to rise, unemployment may take years to fall, said Ellis, who predicts Europe?s rate will exceed the 1997 peak of 10.7 percent next year. The economy may suffer ?hysteresis effects,? as it did after previous slumps, when jobless workers can?t find new positions even in a recovery and become less employable as their skills erode.

The OECD calculates long-term unemployment may rise by 1.5 percentage points to 9 percent by the end of 2010 from 2007, about seven times the increase anticipated in the U.S. and Japan.

Even if companies do want to borrow more to invest and hire, bankers may balk, partly because of concerns about further losses from insolvencies. European banks may lose $283 billion by the end of 2010, on top of $365 billion since the crisis began in 2007, the ECB said in a June report.

Less Aggressive

While the central bank said last week that lenders tightened credit less aggressively during the second quarter, it also reported that loans to households and companies grew at a record-low 1.5 percent in June.

When Frankfurt-based Deutsche Bank reported a 68 percent jump in net income to 1.09 billion euros July 28, Germany?s largest bank also said it set aside 1 billion euros for risky loans in the second quarter, more than analysts estimated.

?The crisis is not over,? Chief Executive Officer Josef Ackermann said July 30. ?Bad loans are the next wave. Banks that have fared relatively well so far will also be affected by this.?

Governments could do more to boost Europe?s long-term growth by spending more on education or making labor markets more flexible, said Juergen Michels, an economist at Citigroup Inc. in London.

?We do not see signs that decision makers are determined to restart with an ambitious reform agenda,? he said in a July 10 report. ?There is little evidence that the euro area will benefit from a quick rebound in the potential growth rate after the end of the crisis.?

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net.

Last Updated: August 2, 2009 19:01 EDT

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