Eurozone PMI held surprisingly well in May despite higher costs and supply disruption

Despite a tightening in financial conditions, increased geopolitical risk due to the Ukraine war, a lower euro exchange rate which increases imported inflation and lower fiscal stimulus in most countries, the eurozone economic recovery continues this Spring but at a slower pace than in 2021 and in early 2022. Eurozone activity in the services sector slowed to a 2-month low of 56.3 versus 57.7 in April. Pent-up pandemic demand explains most of the momentum with a surge in spending on tourism and recreation, in particular. As factories were constrained by widespread supply shortages resulting from the Ukraine war and China’s lockdowns, the manufacturing PMI decreased to a 18-month low of 54.4 versus 55.5 in April. On a positive note, the sector continued to report solid hiring. Though it may not last if inflationary pressures remain in place most of this year (at some point, factories will need to further cut costs, including labor cost). The latest PMI data are consistent with the eurozone economy growing at a solid quarterly rate of 0.6% so far in the second quarter. This is obviously disappointing (remember that many economists expected the start of a second Roaring Twenties after the Covid pandemic ended in Spring 2021). But given all the risks facing the economy, this is an overall positive and encouraging performance.

Key details from the flash PMI report:

• Price pressures remain a major issue with input cost and output charge inflation holding close to record highs. S&P notes that “prices charged for goods and services rose at the second-highest rate yet recorded by the survey, though the rate of inflation cooled slightly compared to April following a second successive monthly easing in firms’ input cost inflation”. Inflation is still uncomfortably high and will remain elevated for a prolonged period of time. The peak in CPI has not been reached yet. Expect the European Central Bank (ECB) to increase interest rates at the July meeting of 21 July (one day after the release of the flash Q2 eurozone GDP) and to exit negative interest rates around September in a move to lower inflationary pressures. The ECB is also likely to express more concerns about FX and the euro exchange rate (in an effort to reduce imported inflation). ECB’s Christine Lagarde indicated this morning the Governing council is “attentive to the level of the euro”. This is a way to get back control of the agenda while hawks are increasingly calling for a bold move to contain inflation too.

• The Omicron variant has no direct impact on the eurozone economy anymore. This is not an issue. Most restrictions have been lifted in recent weeks. In France, mask-wearing is not mandatory in public transport since 16 May and there is no need to show a health pass to enter in restaurants or bars. Life has resumed as normal finally. This partially explains the surge in the service sector observed in several countries.

• The gap between the manufacturing and the services sectors is increasing in France. Whereas the French manufacturing PMI softened to a 7-month low of 54.5, the service sector showed resilience with a flash estimate at 58.4 versus prior 58.9 in April. The manufacturing malaise mostly results from difficult access to raw material and higher prices which weigh on demand. There were mentions of clients being dissuaded from placing orders due to high inflation across the board while other customers decided to adopt a wait-and-see approach, for instance. On top of that, exports in the manufacturing sector continue to decline. This will leave marks on the economy. We see growing evidence of a two-speed economy emerging within France, as the service sector will likely push GDP growth higher in the coming months partially balancing the weakness across the manufacturing industry. We still believe France is at risk of a technical recession this year, especially after the release of the stagnant Q1 GDP and the negative contribution to activity from the final domestic demand excluding inventory (minus 0.6 point in Q1). This is one of the most important indicators to assess the real state of the French economy, in our view.

• The UK PMI data signal a major economic slowdown in May as the cost of living crisis hits customer demand. The services PMI fell to a 15-month low of 51.8 versus 58.9 in April while the composite output index dropped to a 15-month low of 51.8 versus 58.2 in April. These are stunning decreases over such a short period of time. Business expectations are gloomy due to concerns about squeezed margins, weaker order books, record-inflation across the board and geopolitical uncertainty. In the services sector, expectations fell by the most since March 2020 when the pandemic first hit, for instance. The travel, leisure and events sector is the only one experiencing strong growth conditions (for obvious reasons). With inflation out of control (that was acknowledged by the Bank of England recently) and growing risk of compressed domestic demand, we think the United Kingdom is likely to go through a technical recession this year. This is our baseline.