Industrial weakness clouds eurozone outlook

Eurozone GDP growth reaccelerated in the third quarter, to 0.4% QOQ. That was better than expected and underscored that recent PMI surveys for the services sector have been painting too pessimistic a picture. Going forward, growth is expected to soften, however. Even though recent data suggests that weakness might be bottoming out in Germany, they continue to paint a bleak picture and a quick reversal of fortune for Germany seems unlikely.

Meanwhile, the economies of France and Spain are expected to lose some steam in Q4, as the boost from the Olympics fades and tourism-driven growth is expected to soften. Moreover, government consumption is likely to fall due to fiscal tightening, while investments remain rather weak. As a result, eurozone GDP growth is likely to weaken in Q4 before it accelerates in 2025, helped by increased household purchasing power, lower interest rates, and a better global backdrop.

Although the growth figures in the third quarter were decent, they mask the underlying struggles of Europe's industrial sector. While almost the entire industrial complex is suffering from global demand weakness, especially energy-intensive industries are having a hard time. Energy prices, especially gas, soared as the war in the Ukraine broke out, leading to significant declines in production (Figure 2). For instance, in Germany, production plummeted by over 20% and it has yet to recover. While energy prices have fallen substantially from their peak, they are still much higher than before the energy crisis in most countries (Figure 3). Apart from higher energy prices, however, there are broader dynamics at work that have driven the declines in industrial production at different speeds across the block, both pre- and post-energy crisis.

To determine whether this is merely a stroke of bad luck or whether deeper structural elements are at play, we can analyze a country's performance through the lenses of structural and intrinsic effects. The former describe the performance influenced by industry structure: for example, what part of Germany's underperformance can we attribute to its substantial automotive sector? The latter focuses on individual sectors: for instance, has France’s automotive sector outperformed Germany’s? We focus on the five biggest economies in the eurozone.

Digging deeper, we find that a significant part of France’s and Germany’s underperformance occurred prior to the start of the energy crisis (Figure 6). From 2022Q2 to 2024Q4 Germany performed on par with the rest of the EU, while France actually outperformed over that period. This suggests that the hit from higher energy prices does not explain the underperformance.

That leaves us wondering what happened between 2019Q4 and 2022Q2. Figure 7 sheds light on the sectors contributing to the intrinsic effect and their performance relative to the EU27. There are a few sectors that stand out. Firstly, the Computer, Electronics & Optical Products sector experienced a production boom in Central- and Eastern Europe over this period. In Bulgaria for example, production in the sector spiked by 56%. The five countries in our sample didn’t share in that production upswing, which accounts for a portion of the underperformance.

Secondly, there’s also a notable underperformance in Basic pharmaceutical products. This has to do with the fact that Covid vaccines were produced in Belgium (+127% production between 2019Q4 and 2022Q2) and with the Ozempic boom in Denmark (+48% over that period).

What’s interesting is that while much attention has focused on the decline in German industry over the past years, it was in fact France that experienced a more pronounced industrial decline in the pandemic years until the energy crisis hit. Germany underperformed in 11 out of 14 sectors, whereas France lagged behind in 12 out of 14 sectors. The key difference is that France has exceeded the average performance since the energy crisis, unlike Germany.

One reason for Germany’s underperformance is its exposure to China. In recent years, China's struggle to maintain its pre-Covid growth rates has suppressed demand for German exports. Additionally, China has transitioned from being a consumer of German high-tech goods to a producer of such products. This shift not only diminishes Germany's exports to China, but also introduces new competition. Consequently, Germany's trade balance with China, which was fairly balanced in 2018, has now shifted to a significant deficit. Italy is also suffering from increased Chinese competition. Italy might not have the same level of overall direct exposure to China as Germany, but it is losing the game in textiles and clothing production – as well as metals. Furthermore, Italian industry is significantly exposed to developments in German industry. In other words, weakness in Germany has a substantial impact on the production of inputs and intermediate goods, as well as equipment and machinery in Italy.

The big question is whether this two-speed economy will persist or if we will see a convergence of the manufacturing and services sector. Recent surveys seem to suggest the latter. The latest slew of PMI surveys suggests that activity in the services sector is weakening, possibly resulting from industrial weakness spilling over.

However, the PMI surveys are a bit misleading here. Since the pandemic, a repeating pattern seems to have crept into the figures. From the peak (April/May) to the trough (Dec/Jan) this effect may be as large as 6 points on the index. Consequently, the PMIs in the coming months could be less optimistic than one would expect based on the actual economic activity.

We therefore turn to the EC services sector survey, which doesn’t suffer from this effect. When we zoom in on the sub-sectors it is hard to discern a clear pattern. Security and broadcasting services, food and beverages, and tourism-related activities have weakened a little, whereas selected professional business, real estate services and water (+air) transport showed an improvement. A similar analysis of industrial sectors points to more weakness in downstream activities, but a (relative) improvement in upstream activities.

If anything, these observations do not point to negative spillover effects from industry-related weakness, but to underlying weakness in consumer demand. The latter has – indeed – remained surprisingly subdued since 2023.

We expect that consumption growth will soon pick up, however. The recent fall in inflation supports a further improvement in purchasing power, despite the fact that nominal wage growth is slowing (Figure 11). The labor market will support further (gradually more modest) wage gains. Unemployment fell to a fresh record low in July, and although vacancy rates have eased a little, they are still slightly above pre-pandemic levels. We expect that the unemployment rate will fall by just a little from this point and that employment growth will flatline. The growth in real disposable income is thus mainly driven by higher real wages.

All in all, the key message from the eurozone GDP figures in the third quarter is that the slow but gradual recovery remains intact, even as both structural and cyclical challenges are likely to keep a lid on the pace of expansion in coming quarters. Q4 is likely to show a fallback in growth after the Q3 uptick.

For a more detailed report on our economic projections, we refer you to this link.