EU Economy: Weekly Commentary – 8 July, 2024
European Market Review
European bond yields declined due to political tensions and economic concerns, while stocks rose, and oil prices increased on supply threats.

European bond yields declined throughout the week, influenced by escalating political tensions, particularly in France, and a deteriorating economic outlook, which could prompt the ECB may cut interest rates again. The yield spread between benchmark French and German bonds widened by 12.4 basis points over the week. Stock markets across Europe trended higher as economic data weakened, reflecting the paradox where negative economic indicators benefit the markets. The euro appreciated, reaching 1.0839. Additionally, Brent crude oil prices increased by over 2%, driven by supply threats from Hurricane Beryl and a bullish report on oil inventories from the Energy Information Administration (EIA).
Europe View Synopsis
Eurozone's core inflation stables at 2.9%; overall inflation dips to 2.5%. High services inflation (4.1%) and robust wage growth delay ECB rate cuts. Economic growth slowed in Q2, especially in manufacturing and non-domestic markets, with easing price pressures. UK housing prices stabilize amid rising mortgage rates, impacting affordability despite Bank of England rate cuts.

The Eurozone's core inflation remains stable at 2.9%, with overall inflation slightly decreasing to 2.5%. High services inflation at 4.1% and strong wage growth continue to pressure inflation, delaying ECB rate cuts until more data is available. Economic growth slowed in Q2, especially in manufacturing and non-domestic markets, alongside reduced growth in the services sector and easing price pressures. Consumer spending showed signs of recovery with modest retail sales increases, supported by improved real wages despite challenges in the industrial sector. The German manufacturing sector faced ongoing declines in factory orders and production, reflecting broader economic slowdowns and structural weaknesses. In the UK, housing prices stabilized amid rising mortgage rates, impacting affordability despite expectations of recovery following interest rate cuts by the Bank of England.
Eurozone core inflation remained unexpectedly stable. Services continue to exert significant inflation pressure, and wage growth not providing relief.

The eurozone's overall inflation rate decreased slightly from 2.6% to 2.5%, while core inflation held steady at 2.9%. Services inflation remained constant at 4.1%, which has kept core inflation high and hindered potential rate cuts. Wage growth remains high, above inflation, increasing uncertainty around services inflation and making rate cuts even more difficult. Despite projections indicating a potential moderation in services inflation and wage growth, the European Central Bank (ECB) is expected to await further concrete evidence of diminishing inflationary pressures before taking additional action. The robust labour market, underscored by a record-low unemployment rate of 6.4%, supports this prudent stance. Consequently, the ECB is likely to defer any decisions on rate cuts until September, pending the availability of more comprehensive data, while also considering the potential impact of the French elections on market stability.

Given the persistence of inflation and the slight depreciation of the euro against the dollar, we anticipate that the ECB will refrain from any immediate action, aligning its strategy with the Federal Reserve's timeline for the end of the year. This approach aims to maintain stable bond yields and a steady euro.
Business Activity
Economic growth in the euro area slowed at the end of Q2, with declines in manufacturing and new orders, particularly in non-domestic markets. The service sector showed slowed growth, with easing price pressures and decreased employment growth rates.

Economic growth in the euro area slowed to a 3-month low at the end of the second quarter, as evidenced by the Eurozone Composite PMI Output Index, which fell to 50.9 in June from 52.2 in May. This downturn reflects a decline in new orders for the first time since February, with weaker sales particularly evident in non-domestic markets. Additionally, price pressures across the euro area have eased, with input costs and output prices increasing at their slowest rates in five and eight months, respectively, though they remain above pre-pandemic levels.

Manufacturing activity in Europe experienced a decline, with Italy being the only major country to avoid a fall in its PMI, despite widespread price cuts by manufacturers. The final Eurozone manufacturing PMI decreased to 45.8 in June from 47.3 in May, remaining below the 50 mark that separates growth from contraction for two years. The recent spurts of growth seen in previous months appear to be waning, suggesting that recovery in the manufacturing sector will take more time. Germany’s manufacturing sector, which constitutes around a fifth of Europe’s largest economy, saw a decline, while in France, the manufacturing recession intensified.

The Services PMI Business Activity Index indicated higher levels of business activity, registering 52.8 in June, down from 53.2 in May, marking a 3-month low. Although demand in the service sector improved, the growth rate slowed, driven predominantly by local customers as export orders declined marginally. Employment in the service sector continued to grow but at the slowest rate in five months. The backlog of work decreased for the eleventh time in the past year, with the fastest depletion rate since February. While optimism for future service sector output persisted, it was at its lowest level since the beginning of 2024.

We foresee limited improvements in business activity. The manufacturing sector is expected to exert significant downward pressure on European economic growth in Q2 and Q3. We believe a recovery will depend on increased demand and further cuts in interest rates.
Consumer Spending
Eurozone retail sales show a modest May increase amid recovery signs despite being 3.5% below pre-pandemic levels. Improved wages may sustain consumer spending amid industrial sector challenges.

Eurozone retail sales have shown a steady upward trend, marked by a modest 0.1% MoM increase in May signalling a reversal from previous downturns. Despite remaining 3.5% below pre-pandemic peaks, signs of stabilization emerged late last year, albeit with intermittent declines casting doubt until recently. Since March, sales have stabilized at slightly higher levels, indicating an emerging recovery. While cautious optimism prevails and inventories remain high, improved real wages suggest ongoing growth in consumer spending through the latter part of 2024. This gradual improvement in retail sales is expected to support moderate economic expansion, driven by a recovery in household consumption.

We anticipate that wage growth and labour market stability will bolster retail sales in H2 of the year, although they may face challenges from weakness in the industrial sector.
German Industrial Sector
German industry faces ongoing challenges with falling factory orders and weak industrial activity. Despite early-year optimism, high uncertainty and structural weaknesses pose significant risks.

German industry continues to confront substantial challenges, as evidenced by disappointing performance indicators for May. Factory orders unexpectedly declined by 1.6% MoM, marking the fifth consecutive month of decline and underscoring the persistent difficulties for German manufacturers. Orders have decreased by 8.6% YoY, mirroring weak industrial activity consistent with poor manufacturing PMIs and reduced heavy truck traffic. The optimism observed in Q1, fuelled by improving confidence indicators and modest economic growth, has now been supplanted by a more challenging reality. Industrial production dropped by 2.5% MoM in May, following a negligible 0.1% increase in April, with annual output falling by nearly 7%. Significant declines in key sectors such as automotive and construction have contributed to a broader economic slowdown. While the high number of public holidays in May partly explains the decline, a robust recovery in June is essential to avoid a negative quarter.

Persistent high inventory levels and declining orders continue to pose challenges, with May marking the fifth consecutive month of falling industrial orders. Industry uncertainty remains elevated, yet there are indications of a potential recovery. Strong wage growth could bolster private consumption, and a modest industrial rebound is possible later in the year. However, rising oil prices, increasing insolvencies, and structural weaknesses remain significant risks. Despite an encouraging start to the year, the German economy is struggling to sustain momentum and faces considerable headwinds.

In our view, Germany will act as a drag on Eurozone growth, suffering significantly from its manufacturing sector woes. We do not anticipate improvements until the ECB further cuts interest rates.
UK Housing Market
The decline in housing prices is mitigated by increasing mortgage rates, thereby sustaining affordability as a persistent concern despite escalating wages.

House prices demonstrated resilience by increasing 0.2% monthly and 1.5% annually, potentially indicating stabilisation amidst anticipated interest rate reductions by the Bank of England. This modest uptick follows a period of volatility influenced by elevated borrowing expenses, which peaked in 2022, initially causing declines before showing signs of recovery in late 2023. Economists foresee these recent developments as a precursor to renewed confidence in the housing sector, bolstered by recent reductions in mortgage rates from major lenders.

Despite recent challenges, such as consecutive interest rate hikes impacting affordability, the housing market appears poised for recovery following cuts in interest rates and sustained wage growth outpacing inflation. As the UK government contemplates measures to enhance housing affordability, industry players anticipate a potential recovery post-election, supported by forthcoming policy revisions and restored buyer optimism.

Over the past year, there has been a notable decrease in home sales transactions, marking an overall decline of 15% compared to pre-pandemic levels in 2019. Notably, mortgage transactions have dropped nearly 25%, reflecting increased financing costs. In contrast, cash transactions have risen by 5% compared to pre-pandemic levels.
The global housing market is currently experiencing tight conditions. In the UK, we anticipate an improvement once the Bank of England reduces interest rates.
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