Recession Red Flags: Europe’s PMIs and Yield Curve Sound the Alarm

Summary:

• Accelerating Economic Slowdown: The latest PMI data reveals sharp contractions in Germany and France, signaling an increasing risk of recession across Europe.
• Yield Curve Disinversion: The recent disinversion of the German yield curve signals rising recession risks in Germany and the broader Eurozone, with markets expecting the ECB to shift toward rate cuts to support the weakening economy. This mirrors past crises, such as post-German reunification, and indicates slower growth ahead alongside potential monetary easing.
• Monitor ECB Policy: With potential rate cuts on the horizon, keep a close watch on ECB policy decisions, as they could further influence bond markets and currency volatility.
• Defensive Strategies: Investors should focus on defensive positions, such as short-term bonds and quality credits, to mitigate risks in a slowing economy.

This morning’s PMI figures for September have further underscored the growing risks of a recession in Europe, with results falling well below expectations. Both Germany and France saw significant contractions in their manufacturing and services sectors, a worrying sign for the broader Eurozone economy.

PMI Disappointment

In Germany, the manufacturing PMI came in below expectations at 40.3, remaining under the 50-mark that separates contraction from expansion, marking its longest period of decline. The services PMI barely held above water at 50.6, slightly above contraction but still weaker than anticipated. This paints a bleak picture for Germany, where the services sector is shrinking for the first time since March.

Meanwhile, France's services PMI took a sharp dive to 48.3, well below the forecast, driven by weaker demand following the conclusion of Olympic-related activities. The French manufacturing PMI also fell to 44.0, signaling deep contraction in both sectors. The French Composite PMI fell to 47.4, sharply down from 53.1 in August, adding to concerns that France’s economy is faltering faster than expected.

At the Eurozone level, the composite PMI dipped to 48.9, signaling contraction across the board, with only the services PMI showing some resistance at 50.5—just barely above neutral.

Reasons for Weakness

The weak PMIs reflect a broad-based slowdown in demand, particularly in exports, with new orders declining across both services and manufacturing sectors. In Germany, the continued slump in global demand for industrial goods has hit its manufacturing sector hard, while high energy costs and weaker business confidence have further dampened activity.

In France, the end of the Olympic Games-related boost has led to a significant drop in services activity, while its manufacturing sector is grappling with weak demand and declining exports. Political instability following the reshuffling of Macron’s cabinet has also eroded investor confidence, adding to concerns.

Unraveling the German Yield Curve: What Disinversion Signals for Investors

On the back of today’s weak economic data, the German yield curve disinverted for the first time since November 2022, with the two-year yield falling below the ten-year yield, marking an important shift in market expectations and offering valuable insights for investors. Here are key conclusions and their implications:

1. Economic Weakness and Recession Risks:

Disinversion typically signals rising recession risks. The yield curve had been inverted for the past two years, reflecting expectations that the European Central Bank (ECB) would maintain tight monetary policy to combat inflation. The fact that it has disinverted suggests markets now expect the ECB to pivot toward rate cuts to support the economy, reflecting a growing consensus that Germany may already be in a mild recession and that the broader Eurozone is headed in that direction. This shift signals weaker economic growth ahead and increased risks of further economic downturn.

2. Monetary Policy Shift:

The disinversion is also a signal that markets expect the ECB to accelerate the pace of rate cuts, which would push down short-term yields faster than long-term yields. This is in line with the cooling inflation outlook (now close to the ECB's 2% target) and disappointing economic data, such as the weak PMIs for Germany and France. Historically, yield curve disinversion can occur when central banks are expected to provide more accommodative monetary policy to stimulate growth, which now seems to be the case in the Eurozone.

3. Historical Context:

The German yield curve rarely inverts, which makes this recent inversion and subsequent disinversion noteworthy. For example, it didn’t invert during the global financial crisis of 2008-2009, highlighting how exceptional the current economic circumstances are. The last significant inversion occurred in 1991-1992, which was tied to German reunification. At that time, inflation concerns related to vast public spending due to the costs of reunification led to higher long-term yields, while the Bundesbank kept raising short-term, rates to combat inflation. By mid-1992, however, the high short-term rates began to take a toll on the German economy, which was experiencing slower growth. Mounting economic concerns across Europe led the Bundesbank to abruptly lowered short-term interest rates to avoid stifling economic activity causing a sharp steepening of the yield curve. Within that period,  longer-term yields remained relatively stable or rose slightly as inflation concerns eased and investors regained confidence in the long-term outlook for the German economy. This shift led to the re-steepening of the yield curve.