Eurozone data remains volatile amid trade war developments, but the underlying trend is still sluggish. Uncertainty is slowing domestic demand, which contributes to our expectation of a further rate cut from the European Central Bank in September
Eurozone Economy Shows Further Weakness in the Second Quarter
The eurozone economy had been inflated in the first quarter by strong US front-loading effects. Pharma, in particular, saw a significant boost to exports, but other sectors also profited from Americans trying to avoid higher costs for goods. The 0.6% quarter-on-quarter growth rate was the best since the second quarter of 2022, but April industrial production and trade figures poured cold water on any hopes of sustained strength. Production and exports fell by 2.4% and 8.2% respectively, suggesting that the reversal of front-loading effects is now weighing negatively on second-quarter growth.
And the second quarter is also plagued by subdued domestic demand, which leads us to believe that a negative growth print for the period is likely. Services production was down by -0.3% month-on-month in April, and retail sales fell by 0.7% in May. While the timing of holidays may have influenced activity data throughout the second quarter, weakness in the service sector has become a theme in the eurozone in recent months.
In 2Q, Eurozone Services Sentiment Hit Its Lowest Level Since 2013, Excluding the Pandemic
Source: European Commission DG ECFIN
Fearful Consumers and Businesses Weigh on Domestic Demand
For the third quarter, we expect stagnation compared to the second quarter. We don’t expect a full escalation of trade tensions, but a continuation of current uncertainty and trade barriers that could still tick higher from where we are now. The continuation of the “tariff pause” for a few more weeks is unlikely to bring significant relief to the eurozone domestic economy, instead extending a period of uncertainty around the economic outlook for the bloc.
The uncertainty not only makes our lives as forecasters more difficult, but it is also weighing on domestic demand. It is likely an important reason for the sluggish service sector performance in the second quarter. Franklin Roosevelt warned us of this decades ago, but his statement that the “only thing to fear is fear itself” could be falling on deaf ears in the eurozone as economic activity seems increasingly hampered by worried businesses and consumers.
The household savings rate remains at very high levels, which has so far dampened a recovery for consumption. As wage growth still outpaces inflation and employment remains near historical lows, stronger consumer spending could have been expected. But weakness remains.
Chances of a Short-lived ECB Pause Are Increasing
Inflationary pressures have clearly eased, with a fast drop in services inflation reflecting weak domestic demand, low energy prices and a stronger euro. We therefore expect inflation to undershoot the ECB’s 2% target in the coming quarters, and we see the ECB cutting rates one more time in September before pausing indefinitely.
We don’t think the current economy requires the central bank to go much lower than the current 2% on the deposit rate. With substantial public investment starting to trickle through to the economy from next year on, the medium-term inflation outlook is likely to remain around 2%. The current environment of huge uncertainty and lack of direction will likely be followed by activity picking up slowly but surely as public investments make a return to the eurozone at long last.
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