A Tale of Two Eurozones

With Italy slipping into recession in Q4—and Germany narrowly sidestepping one—the common narrative in the financial press seems to be that the overall eurozone is teetering on the brink of a downturn. They see any hint of weakness in data as a sign of its approach. But February’s Purchasing Managers’ Indexes (PMIs)—released last week—suggest eurozone economies are in better shape than this popular portrayal.   

PMIs are surveys measuring growth’s breadth—the percentage of firms reporting growth. They are quite timely, given their monthly frequency and quick publication after month-end. And the questions include forward-looking ones regarding new orders. Useful! But, like all economic data, they aren’t perfect. They don’t give you a sense of growth’s magnitude. If a minority of firms grow or contract a lot, output measures like GDP and breadth measures like PMI can disconnect.

Eurozone composite PMI (manufacturing plus services) rose to 51.9 from January’s 51.0. Readings above 50 mean more firms grew than contracted, so February’s read implies broader growth. It also topped the preliminary estimate, 51.4, a nice surprise.^[i]

Yet you could be forgiven for thinking the eurozone was getting worse—thanks in large part to the popular reaction to eurozone manufacturing PMI’s drop to 49.3 in February, its first contractionary reading in five and a half years.^[ii] Germany (47.6) and Italy (47.7) fell deeper into contraction, while Spain slipped into contraction (49.9) for the first time since 2013.^[iii] Only France improved, registering an expansionary 51.5.^[iv]

Before this reading, observers were reasonably comfortable calling Germany’s slump in 2018’s second half a one-off, tied mostly to the auto industry’s struggles adapting to new EU emissions standards. But February’s contraction, driven in part by continued weak Chinese demand, changed the narrative. Now, people say the prolonged pullback proves the emissions-test-hiccup explanation false, with a painful industrial rough patch looming as China’s woes cause factories to grind to a halt. We don’t dismiss China’s impact, but hoping for a February turnaround always seemed premature. Early year trade with China is routinely disrupted by the Lunar New Year, which falls in January or February and shuts most Chinese factories for days on end. With factories and ports shut, trade ceases, notoriously skewing data. This year, Lunar New Year came late, interfering with trade for much of February.

While manufacturing steals most headlines, services—73% of eurozone GDP—are more important to overall growth.^[v] Eurozone services PMI’s rise to 52.8 was more than enough to offset manufacturing’s fall and drive composite PMI’s improvement. Encouragingly, new orders rose. Since today’s orders fuel tomorrow’s production, this likely bodes well for future eurozone growth. Services expanded in each of the eurozone’s four largest economies. German services jumped to 55.3, its second-highest reading over the past year, with new orders accelerating at a faster rate, boosting the index overall.^[vi] French services, at 50.2, expanded for the first time since the Gilets Jaunes protests began knocking activity in December.^[vii] Even beleaguered Italy enjoyed services expansion, reaching 50.4, perhaps signaling a recovery’s green shoots.^[viii] Spanish services slowed just slightly—to 54.5 from January’s 54.7—but that is still a perfectly fine read.^[ix] Yet improving eurozone services didn’t get anywhere near the attention weak manufacturing did—a sign of sentiment and the potential for positive surprise looking ahead.

Our opinion of the eurozone economy hasn’t changed. Investors still seem hung up on old and weak data, ignoring more recent positive indicators and seemingly underestimating the region’s prospects. The Conference Board’s Leading Economic Index for the eurozone has risen 10 of the last 12 months.^[x] The positively sloped yield curve should continue supporting lending, keeping M3 money supply growing at a decent clip. January’s private sector lending and M3 rose 3.0% y/y and 3.8%, respectively, giving businesses and households plenty of fuel.^[xi] Moreover, recent fiscal and monetary stimulus efforts in China are only just starting to bear fruit. It wouldn’t surprise us to see the eurozone benefit from resurgent Chinese demand, turning headwinds into underappreciated tailwinds.