Midway through the third quarter of the year, economic activity in the Eurozone appears to be entering a period of stagnation. The composite (manufacturing and services) August Flash PMI (Purchasing Managers’ Index) dropped to its lowest level since November 2007. This is the third consecutive month that the index has been in contractionary territory. The service sector, which had been sustaining the Eurozone economies, is reported to be driving the August declines, while the rate of contraction in manufacturing slowed. While the flash estimate of economic growth in the second quarter was a reassuring positive 0.3% advance over Q1, about half of that increase was due to just one economy, Ireland’s.
The gloomy outlook is due in part to a collapse in credit growth. The Eurozone’s money supply declined in July for the first time in 13 years. The European Central Bank tracks the comprehensive M3 money supply, which includes deposits, loans, cash in circulation, and various liquid financial products. As a result of the ECB’s monetary tightening – that is, the increase in the benchmark deposit rate from minus 0.5% to 3.75% and the shrinking of the bank’s balance sheet – lending to both households and nonfinancial corporations collapsed in July. Adding to the ECB policy tightening, banks are continuing to tighten their lending standards. While the ECB may decide as early as their September meeting on a pause in raising interest rates further, the monetary impact of their tightening to date will extend several more months before peaking.
The other major headwind for the Eurozone economy is the weakness of external demand from the region’s trading partners, particularly China. Growth in world trade is expected to be flat this year, with the boost from the reopening of China proving to be much smaller than expected. The industrial sector of the Eurozone economy has been hit hard. Manufacturing output has declined in each of the past five months. New orders for goods are declining sharply. Germany, heavily exposed to manufacturing, has been strongly affected, with its manufacturing sector output falling at an accelerated rate.
In the last two months, the demand for services in the Eurozone also declined, with Germany’s services showing the most marked shift from growth to contraction. With its services sector threatening to join the recession in manufacturing, the German economy is likely to underperform the other Eurozone economies in the second half of the year.
France, the second largest Eurozone economy, is also in a downturn. The Flash France PMI for August showed all activity levels falling solidly, with the economy shrinking for the third straight month. While France’s composite PMI was unchanged from July, it is deeply into contractionary territory. Demand for both French goods and services dropped at accelerated rates. New orders fell for the fourth consecutive month. The weakness in the dominant service sector was unexpected.
Flash August PMI estimates for Italy and Spain aren’t available. It is noteworthy that, of the four largest Eurozone economies, Spain was the only one registering continued positive growth in July.
The deteriorating Eurozone economic outlook may lead the ECB to pause rather than continue to hike rates at its upcoming September meeting. However, last week at Jackson Hole, ECB president Christine Lagarde said, “The fight against inflation is not yet won.” Indeed, core inflation remains at 5.5%, far above the 2% target. Goods inflation is moderating, while services inflation keeps rising. The debate between the ECB inflation hawks and doves is likely to be intense.
We expect that GNP growth for the Eurozone, which was 3.4% last year, will be just 0.7% for the current year and probably no more than 1.0% in 2024. Prospects for France and Italy are similar. Germany’s economic growth figure for this year looks likely to be negative, -0.3%. Spain’s economy is outperforming, with projected growth this year of 2.3%, following a strong 5.5% advance in 2022.
Eurozone equity markets have proven to be surprisingly resilient so far in dealing with the deteriorating economic outlook. Investors may be expecting the current slowdown to be modest. Also, earnings have held up. While the weak PMI reports would be expected to be correlated with downward earnings revisions, the pattern of earnings revisions year-to-date has been roughly flat.
The iShares MSCI Eurozone ETF, EZU, is up 14.9% year-to-date August 29th. Most of that increase was in the first quarter, as the increase over the past three months was just 1.25%. German stocks were affected more negatively. While the iShares MSCI Germany ETF, EWG, is still up 13.6% year-to-date, over the past three months it slumped -1.2%. French equities performed more strongly. The iShares MSCI France ETF, EWQ, gained 15.3% year-to-date and 1.68% over the past three months. The outperformance of Spanish and Italian stocks and their momentum in the last three months is impressive. The iShares MSCI Spain ETF, EWP, has gained 19.8% year-to-date and 5.75% over the past three months. The performance of the iShares MSCI Italy ETF, EWI, over the same periods was 20.4% and 7.0%.
Looking forward, the outlook for Eurozone equities is highly uncertain, with both economic and geopolitical risks. Our International and Global ETF Portfolios are underweight with respect to the region.
One of the securities mentioned in this note, EWQ, is currently held in Cumberland Advisors investments. None are in the author’s investments.
William H. Witherell, Ph.D.
Chief Global Economist
Sources: Financial Times, Oxford Economics, S&P Global, CNBC.com, Goldman Sachs Global Investment Research, Bloomburg.com
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