Euro Area: Sharp Decrease in PMIs Signals Slowdown

• The Eurozone composite PMI decreased sharply to 55.4 in May from 57.4 in April signalling dampened growth in Q2.
• Especially the drop in manufacturing new orders from 57.4 to 53.8 in combination with an increase in stocks of finished goods is worrisome as this could indicate further slowdown in headline PMI in the coming months.
• Following the very strong growth in Q1, we expect growth to be much more modest in the remainder of the year. As a result euro area GDP growth is projected to be around 2% in 2011.
• Despite today's drop the continued elevated PMI levels are in line with an ECB July hike. However, if PMIs over the coming months continue to drop sharply it could influence the length of the ECB's hiking cycle.

Details and outlook

The Eurozone composite PMI decreased sharply to 55.4 in May from 57.8 in April, pulled by a decrease in manufacturing PMI to 54.8 in May from 58.0 in April, while service PMI decreased more modestly from 56.7 to 55.4. The decline is not surprising in light of the elevated levels, but the drop is sharper than expected by both consensus and us.

Especially the drop in manufacturing orders is worrisome. Manufacturing orders dropped sharply from 57.4 to 53.8. Historically this has been a decent predictor of ECB hikes and pauses. We are still above 53, which historically has been the level that signals no further hikes (see ECB: How fast and for how long will ECB hike rates?). New export orders also decreased sharply, from 57.7 to 54.7.

German and French PMI data are broadly in line with the euro area average. However, French service PMI only fell slightly from 62.9 to 62.8. German manufacturing PMI fell from 62.0 to 58.2 and service from 56.8 to 54.9. The decline is not surprising following the very strong Q1 growth, but the drop is sharper than expected. Manufacturing new orders fell from 61.0 to 56.9, while the decline in export orders was less pronounced. French manufacturing PMI fell from 57.5 to 55.0. Manufacturing new orders fell from 56.7 to 54.4, which is the lowest level since August 2009. New export orders fell less and remain at a higher level, 56.4. Stocks of finished goods increased to 50.1 from 47.3 and are now at the highest level since October 2008. Higher stocks and smaller order books clearly signal a slowdown in production.

All in all a disappointing reading that clearly signals a slowdown - in particular in domestic demand - which is a bit alarming. Nevertheless, the levels are still pretty high and today's disappointing data (and the bad news over the weekend for that matter) will not keep the ECB from signalling a July hike. However, if PMIs over the coming months continue to drop dramatically it could influence the length of the ECB's hiking cycle.