While pending emissions legislation hangs over the European auto industry like the sword of Damocles, threatening to reshape the new-vehicle market and pressuring profitability, the near-term outlook isn’t quite so daunting.

Sure local suppliers, like those in other mature markets, are struggling under the weight of lower-cost competition, while more and more vehicle production continues to move eastward, threatening labor in the West. The strong euro is cutting into export profits, and the U.S. housing slump appears poised to make an impact on Europe.

But thanks to demand in Central and Eastern Europe, sales on the continent are going strong, and analysts say that’s likely to continue into 2008.

“European autos is one of the best-performing sectors in 2007,” Goldman Sachs analyst Stefan Burgstaller writes in a recent research note to clients that upgraded an industry outlook to “attractive.”

This year, European light-vehicle sales should reach 21.6 million-22.0 million, forecasters say, up as much as 3.9% from 2006 levels. Next year, the market should grow to 22.6 million units, according to projections by both CSM Worldwide and Global Insight Inc. CSM predicts demand will hit 25 million vehicles in 2013.

Much of the growth is occurring outside the traditional western markets, with sales in Central/Eastern Europe pegged at 6.0 million next year, up 11.1% on 2007’s projected tally of 5.4 million, according to Global Insight. This year’s results should mark a gain of 14.5%-19.5% from 2006, forecasters say.

“Central and Eastern Europe have been strong,” notes Walt Madeira, manager-European sales analysis for CSM. “Going forward, we’re seeing double-digit growth.”

Western Europe has been rather flat so far this year and is likely to finish about on par with 2006 at about 16.7 million units, according to various projections. But 2008 may see some growth behind a comeback in Germany, where sales plunged this year after an increase in value-added taxes curbed buyer enthusiasm.

“Usually, Germany is driving growth, but this year it is pulling the market downward,” Madeira says, adding the release of pent-up demand there next year should propel Western Europe to a 3% gain overall.

The biggest threat to Europe might be the faltering U.S. economy, which Nariman Behravesh, chief economist for Global Insight, says could send a chill wind across the Atlantic.

European Light-Vehicle Sales Forecast
(in millions of units)
Region 2006 2007 2008 2009 2010
Eastern/Central Europe 4.5 5.4 6.0 6.4 6.6
Western Europe 16.7 16.6 16.6 16.8 17.1
Total 21.2 22.0 22.6 23.2 23.7
Source: Global Insight

“Europe is no longer immune to the United States’ economic problems,” he says. “Europe is more vulnerable, more at risk near term (than other regions).”

Behravesh says he’s particularly worried about the housing market in Ireland, Spain and the U.K., which could force an economic downturn that would trickle down to vehicle sales.

“We know (economic) growth will slow in Europe; we just don’t know how much,” he says.

The euro-dollar exchange rate, now at €1:$1.44, presents another headwind for German auto makers, driving them to at least consider moving more production to the U.S.

“We expect the euro to keep appreciating through mid-2009, and we think it is headed for $1.50,” Behravesh warns.

A similar outlook is prompting BMW AG to expand capacity at its Spartanburg, SC, plant from 140,000 units annually to 240,000 by 2012 and is causing Volkswagen AG and Audi AG to mull U.S. capacity of their own.

“We clearly have to consider a production location in North America,” Volkswagen of America Inc. CEO Stefan Jacoby told analysts earlier this year.

And although the European Union still is putting the final touches on new rules to limit carbon-dioxide emissions after 2012, the clean-air movement – backed by advertising encouraging consumers to keep tires inflated and avoid revving their engines in the name of clean air – already is having an effect on the market.

SUV demand is growing at a slower rate, analysts say, and the mix is shifting more to diesel power, particularly in the U.K., where graduated, carbon-based vehicle excise duties already are on the books and stretch out through 2011. For example, a gasoline-powered vehicle that produces up to 120 g/km of CO2 is subject to a tax of £40 ($82), while one emitting 168-225 g/km is taxed at £190 ($388).

“There’s been strong growth with SUVs, but we’ve softened our forecast going forward due to the (upcoming CO2) legislation and anti-SUV sentiment in general, particularly in the U.K.,” Madeira says.

Citing public-service eco-ads equating CO2 conservation with saving penguins, Nigel Griffiths, group management director for Global Insight, jokingly calls SUVs “penguin killers” and suggests a future where new-vehicle pricing stickers that include “a penguin index” geared to CO2 emissions levels might not be too far-fetched.

Conversely, small-car demand is expected to continue gaining, thanks in part to a bevy of new products.

“Small, A-segment cars, led by the new Fiat 500, are exploding,” Madeira says. “That’s a segment that had been dormant for awhile until manufacturers began to pay attention to it again,” he adds, pointing to the Toyota Aygo, Citroen C1 and Peugeot 107 launched in 2005, recently revamped Renault Twingo and Smart Fortwo and upcoming restyled Ford Ka, plus new entries expected from Toyota Motor Corp. and Honda Motor Co. Ltd.

Griffiths says the end to the upsizing movement already is at hand in Europe, pointing to cars that are becoming smaller and/or lighter, such as the third-generation Mazda2, which chopped a few centimeters off in overall length from its predecessor.

Longer-term, he says, the tightening emissions requirements – along with an EU-wide proliferation of U.K.-type CO2-based tariffs by 2010 – will cause additional shifts in consumer buying patterns.

“Car makers may have to change their products,” Griffiths says, predicting the “decay of the SUV trend after 2012” and a similar decline for the too-heavy multipurpose vehicle, or MPV, sector.

“There’s a wedge being driven between car makers and their customers by the tax structure,” he says.

The trick for survival will be to find a way to make money from fuel efficiency.

“The problem is, the industry is making its biggest profits on (the largest, highest-powered vehicles),” Griffiths points out. Most manufacturers “will have to transform their business models or their profitability will be decimated.”

dzoia@wardsauto.com