October 03, 2019
The clouds over the European economy are becoming more ominous by the day with incoming data failing to offer a silver lining. But what is going on? What has happened to the great renaissance that seemed to be within touching distance in 2017?
The eurozone is currently predicted to grow by a mere 1.1% through 2019 and hopes that its slowdown was temporary have been dashed. The ECB, which just unveiled a new easing package, seems to be running out of ammunition. With the detrimental effects of negative interest rates becoming more apparent, it’s not surprising that the ECB is calling for national governments to step in with fiscal measures to help bolster the economy.
The bloc’s troubles don’t begin with one of the usual Southern European suspects. In fact, at the epicentre of the problem lies Germany, the largest economy worth some $4 trillion, which in the past, was the clear leader of the pack, the eurozone’s economic powerhouse. Industry talk suggests that upcoming GDP data will show that Germany went into recession in the third quarter. Where did it all go wrong?
The country was hit by a series of one-off factors which arrived all at once in a perfect storm. First, at the tail-end of 2018, there was the introduction of new EU emissions tests. This slowed car production – often considered the jewel in the crown of the nation’s manufacturing sector. Then there was a drought which left key waterways too shallow to facilitate the transport of fuel and other goods. Then the global slowdown dawned, hand-in-hand with the US-China trade dispute and global trade hit a wall. Given that Germany’s economy is heavily export-oriented, with a high sensitivity to the global, interconnected business cycle, all of this has crash landed on its doorstep.
What’s worse is that the manufacturing sector is no longer limited by supply side constraints: demand is emerging as a key headwind. This stems from the fact that the US and China are among its main trading partners, with the latter being the most important. A Chinese slowdown means that Germany’s primary customer does not exactly have loose purse strings for the time being and overall, the state of German exports has gone from bad to worse. IHS Markit’s PMI for the manufacturing sector (which accounts for roughly one-fifth of the German economy) fell to 41.7 in September – the lowest reading since the global financial crisis a decade ago, which brought the Composite reading (which includes Services) to 49.1. This was driven by spiralling New Orders, which fell by the most in 10 years. This downturn is starting to affect employment in the sector with job losses broadening in September (as illustrated by recent announcements of job cuts from Continental, BMW, Deutsche Bank, Commerzbank, Opel’s reduction of working hours and mounting fears of job losses at Deutsche Bahn’s Cargo division), reaching a scale at which they could start to weigh more heavily on so far relatively resilient consumer confidence, according to IHS Markit economist Phil Smith.
Up until now, construction investment and private consumption have kept the German economy afloat, but for how long?
Economic research is beset by worries that this malaise in Europe’s manufacturing heartland can seep into the service sector. Indeed, this is a real risk and already Eurozone PMI data in September showed that contagion could already be in motion. IHS Markit’s Flash Composite PMI sank to 50.4 in September from 51.9 in August, below estimates of 51.9. That’s just above the 50 mark separating growth from contraction and was the lowest reading since mid-2013. The manufacturing component fell to 45.6, and the services equivalent to 52.0 from 53.5.
Despite the strong ‘de-industrialisation’ trend that played out in the EU over the past decades, the manufacturing sector still plays a significant role in the overall economy. Indeed, manufacturing and services are strongly intertwined. Manufacturing firms use various services as important inputs in their production process. They also bundle their offerings, providing services along with their products (this is known as the ‘servitisation of manufacturing’). Take for example Nespresso, they manufacture coffee machines, but the end, these are linked to a whole host of services; tasting events, masterclasses, recycling of the pods…
Secondly, a number of service activities (cleaning, customer call centres …) are also carried out within manufacturing firms, which may be partly outsourced. In fact, a paper by the European Commission found that the average service content of manufactured goods produced in the EU reaches close to 40% of the total value of final manufacturing goods produced. The bulk of these services are distribution services (15%), transport and communication (8%) as well as business services which ranges between less than 10 to even 20% and more across EU member states. This latter category includes services such as legal and accounting services, R&D, advertising and market research, engineering activities and ICT services.
All of this explains why economists fear that the service sector could become infected with the manufacturing sector’s influenza. For now, it is only showing minor symptoms and services could still scrape by. Moreover, the manufacturing sector could find a bottom – especially if the US-China trade dispute eases off. However, we can’t ignore the new risks facing Europe’s manufacturing industry: The prospect of a no deal Brexit on Halloween and the US will decide on 13th November whether or not it will hit European car imports with tariffs of up to 25%.
Nevertheless, we do not believe that the German economic model has been exhausted. The budgetary discipline and orthodoxy, seems to be quite extreme given the potential opportunities for public investment in infrastructure, education, innovation and fights against social polarisation. Domestic consumption is benefitting from low inflation which gives households more purchasing power, while a potential labour tax cut, if passed by politicians, could be a game changer… A way to switch on the light at the end of the very dark manufacturing tunnel.
Author: Group Investment Office