The euro zone economy has shrunk for the first time in two and a half years, after teetering on the edge of contraction for much of 2011.
The figures which show that Italy, the Netherlands and Belgium have joined Greece and Portugal by entering recession cast doubt on the ability of euro zone economies to pull themselves out of the currency blocs four-year slump.
Across the euro zone as a whole, output fell by 0.3 percent in the final three months of last year, the EU statistical agency Eurostat revealed on Wednesday.
Numerous analysts think activity in many parts of the euro zone will prove to be sluggish in the first quarter of this year as well presenting poor prospects for corporate earnings growth and hence for euro zone equity prices. But for investors, the negative figures have an extra dangerous dimension that was less apparent when the slump began in 2008 a decline in economic activity in individual countries could hit sovereign debt prices by throwing into question some governments ability to meet their debt payments.
Output shrank by 0.7 percent in Italy, one of the countries whose long-term fiscal position is problematic, indicating a deep recession.
Europe had a torrid quarter in Q4, said James Nixon, chief European economist at Société Générale in London. Jennifer McKeown, senior European economist at Capital Economics in London, said, With Greece still on the edge of disaster and the fiscal crisis deepening, the euro zone economy faces enormous challenges.
The challenges are greater in some euro zone economies than in others. Wednesdays figures suggest a two-speed Europe where the peripheral euro zone economies have already entered or are about to enter into recession, while the core euro zone economies in the zones sounder center either declined more gently or even eked out small growth.
A recession is most commonly defined as two straight quarters of falling output.
On the one hand, gross domestic product (GDP) declined in Germany by only 0.2 percent less than many economists had expected. Moreover, survey data suggests it has already returned to growth this year. But the big positive surprise was France, which confounded expectations of a decline in output by chalking up growth of 0.2 percent.
Markets sense of a two-speed euro zone is reflected in sovereign bond rates. The yield on the benchmark German 10-year edged down another 3 basis points (bp) to close at 1.86 percent on Wednesday a rate so low that it offered a negative real return after allowing for euro zone inflation.
After spiking late last year, French 10-year yields have receded sharply. By the end of Wednesday trading they were only 3.11 percent 56bp lower than a year ago, although little changed on the day.
Corresponding Italian yields, however, were 5.74 percent 16bp up on the day and almost a full percentage point higher than a year before.
Yet some analysts think talk of a two-speed economy is overdone, given problems that are either looming or already painfully apparent in several core euro zone economies.
For example, Wednesdays figures show that Dutch output declined as rapidly as Italian output in the fourth quarter. As a small country in the heart of Europe, the Netherlands is highly dependent on trade with other euro zone member states.
Moreover, analysts expect Frances budget deficit to be above 5 percent of GDP this year significantly higher than Italys rate of about 2 percent. This suggests that the French economy has been relatively resilient partly because its government is yet to make the painful fiscal adjustments forced on Italy by the bond markets. Wednesdays national figures showed that strong public investment supported French GDP a headwind that is unlikely to last, given Frances ongoing austerities.
If France were to reduce its deficit rapidly to Italian levels, the 3 percent loss in output would plunge the country into a deep recession. Frances route to salvation lies in performing the tricky tightrope act of cutting the deficit enough to keep bond markets happy but not too much to provoke an economic crisis. Last years spike in euro zone sovereign yields in response to fears about government solvency suggests that bond traders are not a patient breed.