European investors look past Ukraine, focus on ECB

By Marc Jones

LONDON (Reuters) - European markets advanced despite the conflict in Ukraine, focusing on whether the European Central Bank will announce plans for economic stimulus when it meets this week.

Ukraine reported its forces were under fire from Russian tanks again on Monday, as new signs emerged that the turmoil was damaging the European economy.

Manufacturing output in the euro zone grew at its slowest pace in more than a year and factories reported falling orders as weakness showed up in most corners of the region.

"Although some growth is better than no growth at all, the braking effect of rising economic and geopolitical uncertainties on manufacturers is becoming more visible," said Rob Dobson, senior economist at Markit.

"France remains a real concern, as does Italy's descent from solid expansion to stagnation. Signs that growth impetus waned in the key industrial engine of Germany, and in Spain and the Netherlands, too, is also less than reassuring."

Even so, shares on Europe's FTSEurofirst 300 index largely held their ground after markets in Asia shrugged off some disappointing data from China.

U.S. markets were closed for the day, but gains by bonds from the euro zone periphery suggested that appetite for risk remained alive. The euro also recovered to $1.3133 after reaching a one-year low against the dollar overnight.

Geopolitics remained front and centre. Ukrainian President Petro Poroshenko accused Russia on Monday of "direct and undisguised aggression", after warning over the weekend of a possible "full-scale war".

European Union leaders were drawing up new sanctions against Moscow. EU sources told Reuters that Europeans could be barred from buying new Russian government bonds. Another said the EU might restrict its gas exports and limit industrial use if Russia starts to clamp down on supply or push up prices.

Moscow appeared in no mood to back away, though. Vladimir Putin had called on Sunday for talks on the "statehood" of southern and eastern Ukraine, and as fighting continued in Ukraine his foreign minister, Sergei Lavrov, hinted Russia would hit back if Europe imposed new sanctions.

With Russia's economy already struggling, the threat of new European action pushed dollar-traded shares in Moscow down 1 percent, the rouble to a record low and Russian borrowing costs to a five-year high.

The euro, in contrast, barely budged throughout the European day. Core euro zone bond yields remained at record lows and the dollar index held near a 13-month high.

ENTER THE DRAGHI

Chancellor Angela Merkel acknowledged that enacting further sanctions against Russia might hurt the German economy but said doing nothing was "not an option".

The European Central Bank meets on Thursday and is the prime event for markets seeking clarity on the euro zone's response to a stalled recovery, disappearing inflation and the sluggish pace of reform.

Inflation in the 9.6 trillion euro economy dropped to a five-year low of 0.3 percent in August, a sign that the euro zone's cushion against Japan-style deflation is getting thinner.

Benoit Coeure, one of the ECB's top policymakers, said in an interview over the weekend that the bank is ready to adjust its monetary policy further if needed. French Prime Minister Manuel Valls also repeated his calls for the ECB to tackle the problem of an over-valued euro.

"Pressure for the ECB to do more has returned, not only because of weak output/inflation data, but mostly following (ECB President Mario) Draghi's speech in Jackson Hole," said Frederik Ducrozet, senior euro zone economist at Credit Agricole. Draghi said last month the ECB was prepared to respond with all "available" tools if inflation drops further.

CHINA DISAPPOINTS

U.S. markets were closed on Monday for the Labor Day holiday but it will be a busy week for markets, with central bank meetings in six of the G-10, three major emerging markets and U.S. jobs data on Friday.

MSCI's broadest index of Asia-Pacific shares outside Japan had ended up 0.25 percent and Japan's Nikkei stock average finished 0.3 percent higher.

The gains came even after an official index of Chinese manufacturing fell from a 27-month high in August. That was still the second-highest reading this year.

"The economy still faces considerable downside risks to growth in the second half of the year, which warrants further policy easing," said Qu Hongbin, an economist at HSBC.

The weaker-than-expected data weighed on oil prices. U.S. crude slipped about 0.4 percent to $95.60 a barrel after marking a monthly loss in August. Brent was off 0.4 percent at $102.81 a barrel and growth-attuned metal copper also sagged.

The dollar rose slightly against the yen to 104.17, moving back toward last week's seven-month high of 104.49. The Bank of Japan is one of those meeting this week, and it is expected to hold fire for now despite weak economic data last week.

(Additional reporting by Lisa Twaronite in Tokyo, Martin Santa in Brussels; Editing by Larry King)