• The euro area PMIs edged slightly higher in February but fell short of indicating an imminent rebound in activity. We are tracking flat growth again in Q1.
• It’s increasingly clear that weakness in German economy is holding back the euro area recovery. Long-term structural challenges combined with the prospect of slowing global growth this year mean that it’s hard to make a case for much support from external demand. That leaves growth prospects resting on stronger domestic consumption on the back of better real income conditions. This should support the recovery to an extent, but it’s likely to be another tough year for the German economy overall.
• The PMIs gave further evidence that the UK recession is likely to be mild and short-lived. However, the trend for increasingly firm sentiment could be punctured if the BoE fails to meet expectations for monetary easing this year.

Evidence for an imminent rebound in the euro area economy remains limited

The flash euro area PMIs for February picked up a little but did not point to an imminent acceleration in the economy. The composite output figure increased to an eight-month high but is still in contraction territory at 48.9 (Chart 1). There are some hints of improving momentum in with the future output index at a 10-month high, and better news in the services sector more broadly, but any evidence for a significant pick-up in activity this quarter remains limited overall. We are still tracking GDP growth at 0.0% Q/Q again in Q1, with the German economy continuing to weigh on overall activity (more on this below).

Chart 1: The PMIs remain consistent with weak euro area growth in Q1

Chart 2: A range of measures show that underlying inflation pressures continue to ease

That said, we continue to expect that sentiment, and the outlook in general for the euro area economy, will improve further ahead with consumer spending responding to positive developments on the real income front. Euro area consumer confidence edged up slightly in February, but the series remains well below the long-term average and there is scope for stronger gains ahead. Underlying price pressures continue to ease (Chart 2) and headline inflation should fall towards the ECB’s target over coming months which should boost confidence. Encouragingly, the PMIs continued to suggest that the impact from Red Sea shipping disruption on prices remains limited (Chart 3).

Chart 3: Still only limited evidence of events in the Red Sea pushing up prices

Chart 4:  Nominal pay growth may well have peaked now in the euro area

On the other hand, the PMI release also showed that output price pressures in the services sector have risen continuously since last October. That may cause some consternation among policymakers at the ECB, with pay pressures now the key obstacle to inflation returning sustainably to target.

There was some encouraging news on that front this week with figures showing that negotiated wage growth in the economy as a whole slowed from 4.7% in Q3 2023 to 4.5% in Q4 2023. It looks as though the peak could now be in for nominal pay growth now (Chart 4) and we expect the data to show further easing of pay pressures this quarter. The data for Spain, the euro area’s fourth largest economy, is published on a more frequent basis and fell sharply in January.

The euro area aggregate negotiated wage data for Q1 will be released on 23 May, just before the ECB meeting on 6 June which market participants currently see as the most likely point for an initial rate cut. Minutes of the ECB’s January meeting were also released this week (see here) and did little to change our reading of events (review here). The ECB seems increasingly confident that its policy is working, noting that the disinflationary process is “well on track” as a result of “the ongoing strong transmission of tighter monetary policy”, but it seems it still wants more data to confirm that is the case before starting to cut rates.

The German economy is holding back the euro area recovery

The PMIs also confirmed that it remains a ‘two speed’ euro area economy, with a clear distinction between weak survey data for Germany and France (the two largest economies) and better sentiment elsewhere (Chart 5). That said, while sentiment in France is still weak overall, the French composite PMI did improve sharply in February (and there was also a decent jump in the national INSEE manufacturing confidence gauge). This contrasts with further deterioration in German sentiment. The German composite PMI has been below the breakeven mark since June last year and the more reliable ifo survey also remains weak.

It’s clear that the German economy remains a brake on overall euro area activity. The latest estimate of German growth in Q4 (see here) remained unchanged at -0.3% Q/Q. We’ve talked about the tough situation for German industry previously (e.g. here) and output in the manufacturing sector fell by 2.2% across the quarter. It remains hard to see what can drive a meaningful recovery for the export-orientated German industrial sector this year. The long-term structural challenges from increased Chinese competition in the auto space and the upward shift in energy costs after the end of cheap Russian pipeline gas will both remain in place. There might be some support from a turning global inventory cycle with stock depletion through 2023 weighing on manufacturing activity to an extent.

But, in general, the external environment is likely to get somewhat tougher this year with global growth set to ease. The US economy was notably strong through 2023 and, while it has carried notable momentum into the new year, we still look for a cyclical slowdown as higher interest rates continue to pass through and squeeze aggregate demand. This would be an unwelcome development for the beleaguered Germany economy – the US accounts for around a third of German extra-European goods exports. We also expect slower Chinese growth this year.

Chart 5: A two-speed euro area economy?

Chart 6: Investment dragged heavily on Q4 2023 growth in Germany

Hopes will therefore rest on domestic demand, and consumer spending in particular, becoming a growth driver for the German economy. The expenditure breakdown of Q4 GDP (Chart 6) showed that there was a small increase in private consumption (0.2% Q/Q). We expect stronger contributions from households in coming quarters as real wages recover through the year (disposable income increased by 4.4% Y/Y in Q4 and we look for German inflation to fall towards 2% by year-end). Stronger consumer spending may allow the economy to stave off recession, just about – after the Q4 contraction we are tracking German Q1 GDP at 0.0% in Q1. We expect improving quarterly growth rates later in the year, but the annual average rate is likely to be a muted 0.2% or so after the negative carryover effect from weak activity in H2 2023. So the outlook may brighten somewhat, but overall it looks set to be another tough year for the German economy.

The UK recession looks set to be mild and short-lived

The UK composite PMI continued to increase in February and now stands at a healthy 53.3. Forward-looking components also improved, suggesting that momentum should remain firm. The survey is consistent with GDP growth of around 0.25% in Q1 this year. However, the PMI doesn’t cover the retail or government sectors. These were key areas of weakness behind the 0.3% GDP contraction in Q4 2023 and both have scope to rebound this quarter, so risks to that figure could be on the upside. Our view remains that the UK’s technical recession is likely to be mild and short-lived.

That said, survey data has pointed to some reasons for caution around the outlook. First, the GfK consumer confidence index edged lower in February. We expect the general trend for improving sentiment will resume as real income growth recovers this year. However, the survey also showed an increase in the savings index. If households were to start to squirrel away more cash that would weaken our expectations for a consumer-led recovery in 2024 to an extent. Second, the PMI release noted that optimism was, at least in part, linked to “lower borrowing costs” amid firmer expectations for BoE rate cuts. There is a risk that sentiment, both for consumers and businesses, could be punctured somewhat if the BoE fails to deliver the expected degree of easing. Market participants have gone from pricing in over five rate cuts at the start of the year to around three currently.

Data on underlying price pressures remains mixed. The services PMI price indices have remained broadly stable for several months. However, the employment index continued to increase in February, and the release also highlighted comments from respondents about higher labour costs in the services sector. On the other hand, the Xpert HR measure of pay growth (which has been cited by the BoE previously) fell sharply to 5.1% Y/Y in the three months to January.

On inflation, it was also announced this week that the household energy price cap will fall by 12.3% from April. This was slightly less than we expected but, by our reckoning, should still help drive inflation to the BoE’s target rate in Q2 this year. Further ahead, persistent services price pressures may contribute to higher headline rates higher towards year-end. So the BoE may see a window of opportunity to go ahead with the initial rate cut before that happens – it would be something of a communication challenge to start cutting when headline inflation is on the rise again, even if there is a conviction that underlying pressures are easing.

Next week – Is the disinflation process back on track?

The focus next week will be euro area inflation in February. The flash release is likely to show that the disinflation trend has resumed after a temporary hiccup around the turn of the year relating to base effects in the services sector. We expect both headline and core rates will fall. There will also be data on euro area money supply, unemployment rate and the European Commission’s economic sentiment survey released next week. 

Key data releases and events (week commencing Monday 26 February)