A sharp fall in economic activity data for early 2009 suggests the Euro-Area recession is deeper than earlier expected. According to Citi analysts, record low business and consumer sentiment readings are likely to signal a further fall in activity in coming quarters. Taking this into account, Citi’s forecast for 2009 GDP growth has been revised downwards from -2.8% to -4.3%.

Despite this downgrade, Citi analysts believe fiscal stimulus measures including ‘bank rescue’ programs, will support economic activity in the second half of the year, however it is doubtful that these measures are enough to offset the negative impact of the credit crunch.

The deep recession and the recent strengthening of the euro could contribute to a large fall in inflation and raise the risk of deflation. Citi analysts believe the European Central Bank (ECB) may start to acknowledge this, and cut interest rates to 0.5% in mid 2009. In addition, the ECB would probably need to use unconventional measures such as Quantitative Easing (QE) and asset purchases.

According to historical data, the average bear market rally has seen the market rise by 15%. Indeed, attractive valuations, low interest rates and lead indicators all suggest markets are closer to the bottom than they were six months ago. However, the risk of deflation and falling GDP forecasts continue to pose downside risks.

Citi analysts continue to prefer high dividend-yielding companies with strong balance sheets and positive earnings trends. In particular, Citi analysts are overweight in defensive sectors such as Health Care and Telecoms while being underweight in Industrials and Utilities.