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Investors pin growth hopes on U.S. as Ukraine crisis casts shadow on Europe

By John O'Donnell

FRANKFURT (Reuters) - With the prospect of stiffer sanctions against Russia rattling confidence in Europe, investors will be looking to the United States and China to underpin the global economy.

Wednesday's U.S. gross domestic product (GDP) reading and jobs data on Friday will help markets to judge the strength of the economy's rebound and the likely speed of the Federal Reserve's return to more conventional monetary policy. The Fed meets on Tuesday and Wednesday.

"The U.S.-China story is looking more encouraging," said James Knightley, an economist with ING. "With the European Central Bank's moves, that should allow the euro zone economy to swing upwards but with a good six- to 12-month lag."

In Europe, the downing of a Malaysia Airlines airliner over eastern Ukraine has left countries such as Germany with little choice but to change their long-passive stance and impose tougher sanctions on Moscow over the role of pro-Russian separatists.

Early this week, European Union ambassadors are expected to meet to finalise sanctions that could include closing EU capital markets to state-owned Russian banks, placing an embargo on arms sales and restricting supply of energy technology.

Globally, such sanctions would bite hardest in Europe, where Russia does most trade, compounding economic problems not only for Russia but throughout the region.

The International Monetary Fund has already flagged the 'chilling effect' on investment in Russia of sanctions as it pared back its forecast for global economic growth last week.

Confidence amongst businesses in Germany, which accounts for more than one quarter of all exports across the European Union, has dipped further since the plane crash.

"The situation is very dangerous," said Michael Heise, chief economist of Allianz, one of the globe's largest fund investors.

"An escalation carries large risks for the economy," he said, cautioning in particular of the knock to confidence. "There is a big risk from further sanctions although one has to accept that clear (diplomatic) signals are needed."

BOUNCE-BACK

The crisis comes at a delicate moment for the 18 countries using the euro, where a fledgling recovery is losing pace. Investors will get a snapshot of the bloc's inflation rate, which has sunk well below the European Central Bank's target, on Thursday.

With Britain, one of the stronger European economies, caught up in the push for mutually painful sanctions against Russia, economic growth prospects hinge on the United States and China.

"We think there is going to be a bounce-back in (U.S.) gross domestic product," said ING's Knightley. The Reuters consensus shows annualised growth picking up to 3 percent in the April-June quarter.

Data from Beijing is expected to confirm China's economy picked up in July after government moves to boost lending to business, such as reducing the amount of cash banks must hold in reserve.

China's economy grew at 7.5 percent in the second quarter. But the drags on growth, including a downturn in property prices and high local government debts, are similar to those in Europe.

Analysts believe that deeper reforms, such as overhauling giant state companies, will be needed in the long term to keep the economy growing at the pace the authorities want.

That keeps the focus on U.S. Federal Reserve and how fast it will run down the stimulus that has pumped cheap money around the world, prompting investors to take increasing risks.

The Fed gathers on Tuesday for its two-day meeting but no change of course is expected yet.

Earlier this month, Federal Reserve Chair Janet Yellen signalled that she would keep the central bank's purse strings loose until the effects of the financial crisis are "completely gone."

But some analysts say the central bank may be forced to take a stricter approach to avoid pumping up market bubbles.

"People worry that the Fed may raise interest rates earlier than expected," Nie Wen, an analyst with Hwabao Trust in Shanghai, told Reuters. He predicts a rise in interest rates as soon as early next year.

Michael Heise of Allianz warns that keeping money too cheap for too long carries a major risk.

"If the central banks stay too accommodative for too long, you can have a boom ... and it can come to a massive correction."

In a reminder of the delicate balance facing financial policymakers, Argentina will seek next week to reach agreement with investors suing the country for full repayment of their bonds.

President Cristina's Fernandez's unflinching stance would appear to indicate that the country will go down to the wire. If talks fail, Argentina faces its second default in 12 years.

(Additional reporting by Kevin Yao in Beijing, Adrian Croft in Brussels and David Chance in Washington; Editing by Ruth Pitchford)

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