German Chancellor Angela Merkel gives a tepid bounce to the official ball for the FIFA World Cup, watched by a sombre national coach, Joachim "Jogi" Löw and a smiling Theo Zwanziger, President of the German Football Association (DFB), Wednesday, Feb 10, 2010.

The European sovereign debt crisis may hit already-tepid growth which US investment bank Morgan Stanley had forecast at 1.2% in 2010. Data last week showing Q4 2009 expansion at 0.1% and a poor start to the current quarter, mainly related to very bad weather, underscore the downside risks and the impact of even dramatically slower growth in Europe would only trim US growth fractionally; Asia is far more important for the US outlook However, Morgan Stanley's top economist, Richard Berner, says the debt 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 MS more cautious about risky assets.

Challenge to sustainable growth: Berner says strong growth abroad is one of four pillars for the MS 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.  Thus, a slowdown in Europe's economies would at least challenge that thesis.

He says 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, MS expects 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; MS forecasts the euro to decline to 1.24 EUR/USD. 

Quantifying the fallout for the US:  MS estimates 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 the MS 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%.  MS sees upside risks to both those sources of export vigour.

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 (2-3%) from the likely rise in US earnings this year. MS says 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 Q3 2009, and claims on all European residents amounted to only to 4.6% of total assets. Richard Berner says:"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."

Cross checking:  Berner says to cross-check these results, MS 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 the MS back-of-the-envelope calculation of a 0.2% impact from a similar change in Europe alone.

Contagion tail risk: The base MS 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 MS says 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.

How will European debt concerns impact the trading week and the overall global economy? Robert Barbera, of ITG, and Michael Farr, of Farr, Miller & Washington, share their insight: