Euroland: PMI Warns that the Recovery is Fragile

• Euroland flash PMI increased less than anticipated in June. We believe that PMI will increase strongly in the coming months, but there is a risk that we will not reach levels above 50 (which signals expansion) before late autumn.
• The new order-inventory balance stays at a record high level, which signals sharp increases in PMI in the coming months. The new orders index is still improving, while stocks have started to increase slightly from record lows.
• Today's data indicate that the case for a recovery in Euroland remains fragile. We still expect to see positive GDP growth in Q3, but it could be very modest. Growth is likely to peak in Q4 as inventory investments recover and exports rebound.
• The composite PMI index indicates that the two-year government spread to the ECB refinancing rate is too high as the market has priced in rate hikes faster than the ECB is likely to deliver. Ifo expectations sent the same signal yesterday.

Details

Euroland flash PMI disappointed today as the composite index rose moderately to 44.4 in June from 44.0 in April while consensus had expected an increase to 45.2 and we had anticipated an increase to 46.3 after we received very promising ZEW expectations last week. Manufacturing PMI continued to increase, but not at the same pace as in previous months.

The manufacturing new orders index continued to increase, but the speed of improvement is tapering off - in particular for export orders. At the same time, inventories of both finished goods and stocks purchased increased slightly from record lows. As a result, the manufacturing new order-inventory balance has declined slightly from a record high level, but is still signalling a very strong rebound in manufacturing PMI in the coming months.

Services PMI declined slightly, which was a big disappointment. The very downbeat confidence in the service sector is a reminder that domestic demand in Euroland is very weak - and Euroland will to some extent depend on the rest of the world (in particular Asia) to pull it up.

Flash PMIs for Germany and France released earlier today showed improvements in manufacturing PMI for both countries, but service PMIs declined. Manufacturing PMI increased more for France than Germany and is now at a significantly higher level in France.

Finally, the composite employment index recovered slightly from a 10-year low reached in April. Still the level is very subdued and signals that unemployment will rise sharply in Euroland this year. The services sector employment index improved quite sharply, while improvements in construction and manufacturing were modest. The employment index tends to be a lagging indicator.

Assessment & Outlook

Today's data indicate that the anticipated manufacturing recovery in Euroland is fragile. PMI so far signals that production is falling at a slowing pace. We still believe that PMI will pick up strongly in the coming months despite the slowdown this month, but there is a risk that we will not reach levels above 50 (which signals expansion) before late autumn. We still expect to see positive GDP growth in Q3, but it could be very modest. Growth is likely to peak in Q4 as inventory investments improve and exports rebound.

Manufacturing PMIs currently signal that France could recover faster than Germany. We expect that Germany will benefit substantially from a rebound in global trade and could easily see Germany as the locomotive that will lead Euroland out of the crisis. The new orders index is improving strongly in both France and Germany.

The composite PMI index indicates that the two-year government spread to the ECB refinancing rate is too high as the market has priced in rate hikes faster than the ECB is likely to deliver. The same signal was sent by Ifo expectations yesterday. A temporary setback in government yields is a possibility - and will almost certainly happen if the ECB officially signals that it will keep rates at a low level for an extended period. However, the ECB is probably rather unwilling to send such signals in a more outspoken way. It is more likely that the gap will be closed by the Ifo expectations index catching up with the yield spread.

The steep improvement in PMI is in line with our expectations that GDP growth will become significantly less negative in Q2 than it was in Q1 and Q4 last year. The production levels appear to have become too subdued relative to demand and with very low stocks and an easing in the pace of decline in new orders we project positive growth in Q3. Nevertheless, due to the very negative GDP data for Q1, we now think that Euroland GDP will decline around 3.6% this year.

Bottoms in PMI tend to coincide with bottoms in bond yields and hence today's data points to higher bond yields over the next three to six months in Euroland.

Danske Bank
http://www.danskebank.com/danskeresearch

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