town rat
By William H. Witherell, Ph.D.
In the middle of the third quarter of the year, economic activity in the euro zone appears to have entered a phase of stagnation. The composite (manufacturing and services) August Flash PMI (Purchasing Managers’ Index) fell to its lowest level since November 2007. This is the third month in a row that the index has been in contraction territory. The services sector, which had been supporting euro-zone economies, was reported to be responsible for the declines in August, while the rate of contraction in manufacturing slowed. While the flash estimate of economic growth showed a reassuring positive increase of 0.3% in the second quarter compared to the first quarter, about half of this increase was attributable to just one economy, Ireland.
The bleak outlook is partly due to a slump in credit growth. The money supply in the euro zone fell for the first time in July time in 13 years. The European Central Bank keeps track of M3, the broad money supply that includes deposits, loans, currency in circulation and various liquid financial products. Lending to both private households and non-financial corporations collapsed in July as a result of the ECB’s tightening of monetary policy – i.e. the increase in the key interest rate for deposits from minus 0.5% to 3.75% and the reduction in banks’ balance sheets. In addition to tightening ECB policy, banks continue to tighten their lending standards. While the ECB may decide to pause further rate hikes as early as its September meeting, the monetary impact of its tightening to date will continue for several months before peaking.
The other major headwind for the euro zone economy is weak external demand from the region’s trading partners, particularly China. Global trade growth is expected to stagnate this year, with the impetus from China’s reopening being much weaker than expected. The industrial sector of the eurozone economy has been hit hard. Manufacturing output has declined in each of the last five months. New orders for goods are falling sharply. Germany, which is heavily dependent on manufacturing, was hit hard as manufacturing output fell at an accelerated pace.
Demand for services has also declined in the eurozone over the past two months, with services in Germany showing the clearest shift from growth to contraction. With the service sector threatening to join the manufacturing recession, the German economy is likely to underperform the rest of the eurozone economies in the second half of the year.
France, the second largest economy in the eurozone, is also in a downturn. The Flash France PMI for August showed a sharp decline across all activity levels as the economy contracted for the third straight month. While France’s headline PMI was flat from July, it is heavily in contractionary territory. Demand for French goods and services fell at an accelerated pace. New orders fell for the fourth straight month. The weakness in the dominant service sector came unexpectedly.
Flash PMI estimates for August for Italy and Spain are not available. Notably, Spain was the only country to record sustained positive growth in July out of the four largest eurozone economies.
The deteriorating economic outlook for the euro zone could prompt the ECB to pause at its upcoming September meeting rather than raise interest rates further. However, ECB President Christine Lagarde said in Jackson Hole last week: “The battle against inflation is not yet won.” In fact, core inflation remains at 5.5%, well above the 2% target. Goods inflation is moderating while services inflation continues to rise. The debate between the ECB’s inflation supporters and inflation doves is likely to be intense.
We expect GDP growth for the Eurozone, which was 3.4% last year, to come in at just 0.7% this year and probably no more than 1.0% in 2024. The prospects for France and Italy are similar. Economic growth in Germany is likely to be negative this year at -0.3%. Spain’s economy is outperforming with forecast growth of 2.3% this year after strong growth of 5.5% in 2022.
Eurozone equity markets have so far proved surprisingly resilient in dealing with the deteriorating economic outlook. Investors may expect the current slowdown to be moderate. The yields have also held up. While one would expect the weak PMI reports to coincide with earnings downgrades, the pattern of earnings revisions has remained roughly the same year-to-date.
The iShares MSCI Eurozone ETF, EZU, is up 14.9% year-to-date since August 29. Most of that increase came in the first quarter, as the gain over the trailing three months was just 1.25%. German stocks were hit harder. While the iShares MSCI Germany ETF, EWG, is still up 13.6% year-to-date, it has fallen -1.2% over the past three months. French stocks outperformed. The iShares MSCI France ETF, EWQ, is up 15.3% year-to-date and 1.68% over the last three months. The outperformance of Spanish and Italian equities and their momentum over the last three months is impressive. The iShares MSCI Spain ETF, EWP, is up 19.8% year-to-date and 5.75% over the last three months. The performance of the iShares MSCI Italy ETF, EWI, was 20.4% and 7.0% over the same periods.
Looking ahead, the outlook for Eurozone equities is highly uncertain and involves both economic and geopolitical risks. Our international and global ETF portfolios are underweight in terms of region.
One of the securities mentioned in this release, EWQ, is currently held in investments by Cumberland Advisors. It is not an investment by the author.
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Editor’s note: The summary bullet points for this article were selected by Seeking Alpha editors.
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