Euro Macro: Eurozone PMIs signal that weakness is spreading to the domestic economy – The eurozone composite PMI dropped to 50.4 in September, down from 51.9 in August. The indicator has fallen to its lowest level since July 2013, as the weakness that started in the manufacturing sector and trade is spreading to domestic demand and services. The eurozone services PMI declined sharply in September (to 52.0 from 53.5 in August). What is more, the recession in manufacturing deepened further, pointing to further headwinds ahead for the overall economy. Indeed, the forward looking components of the manufacturing PMI plummeted, with the new orders component falling to its lowest level since mid-2012 in September (to 43.2 from 45.9 in August). Evidence for the weakness spreading to domestic demand was also given by a further decline in the employment component of the composite PMI, which fell to levels in line with stagnating employment and modestly rising unemployment.
Recession risks – Overall, the data are in line with our scenario for a further slowdown in eurozone economic growth towards stagnation levels and we stick to our below consensus GDP and inflation forecasts. Indeed, downside risks are intensifying given recent data and the risks of a recession are rising. One concern is that the recession in manufacturing shows no signs of a abating, suggesting that the negative knock-on effects to the domestic economy could continue. In addition, the new orders component of the composite PMI fell below the 50-mark (to 48.8 from 50.5 in August). It was very marginally and briefly below the 50-mark at the start of the year, but as Markit (which produces the survey) notes ‘firms will increasingly look to reduce output unless demand revives’. The composite new orders index has been below the 50-mark in some periods (in 2001 and 2003) with stagnation rather than recession following. More recently (2008-2009 and 2011-2013) below-50 readings over prolonged periods have coincided with contracting GDP.
Step up in monetary stimulus – We maintain the view that weakness in the economy and subdued inflation will trigger additional monetary easing. We expect another rate cut and a step up in the pace of net asset purchases. ECB President Mario Draghi’s comments before the European Parliament’s Economics and Monetary Affairs committee were consistent with this view. He said that ‘the longer the weakness in manufacturing persists, the greater the risks that other sectors of the economy will be affected by the slowdown’ adding that manufacturing indicators showed no ‘convincing signs of a rebound in growth in the near future’. He said that the Governing Council stands ‘ready to adjust all of our instruments if warranted by the inflation outlook’.
Market impact – In our view, economic weakness and a new round of stimulus suggest that long rates and government bond yields will see a new leg down and will eventually surpass previous record lows, with curves (2s5s and 2s10s) flattening. In contrast, the weakness in the economy will likely be bad news for credit spreads. (Aline Schuiling & Nick Kounis)