Europe fears manufacturing meltdown will infect rest of economy

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MADRID/PARIS (June 12): European industry is in trouble and there’s a risk it will infect other parts of the economy, deepening the slowdown that’s already left the region fragile.

Concern is growing in markets and even at the European Central Bank that the services sector won’t be able to withstand a broader manufacturing slump. That would undermine jobs growth and domestic demand, the main pillars propping up confidence in the outlook for the euro-area economy.

Resilience in other areas such as transport and technology has helped to cushion the blow of a manufacturing sector beset by escalating trade tensions, weaker demand in China, and troubles in the car industry.

But services can’t remain immune for long, and worries are permeating the highest level of policy making. ECB President Mario Draghi last week called this contagion the “key issue” motivating officials to raise the prospect of interest rate cuts. Bank of France Governor Francois Villeroy de Galhau said Wednesday that the Governing Council is ready to act if the economy slows sharply.

“The bright side is that domestic demand remains quite resilient to all these external factors,” said Nicola Nobile, an economist at Oxford Economics. “Can this last forever? Of course not. One of the two will have to converge.”

The risk is that fewer manufacturing orders means companies hire and invest less, dragging further on growth. Confidence could also suffer, making businesses and consumers more cautious, with a fallout on demand for bank lending.

For now, the source of the continent’s manufacturing slump is centered in Germany. Its Purchasing Managers Index has suggested contraction every month this year. France, Spain and Italy look in better shape, but growth is still barely better than stagnation.

“The service sector is still holding on, and investment is still moving forward... The key issue is: how long can the rest of the economy be insulated from a manufacturing sector that keeps on being weak?”-ECB President Mario Draghi, June 6

The stakes are high because services account for about three quarters of euro-zone output. A drop off in trade has already hit the air cargo market, with freight volumes down almost 5% in the past year. Deutsche Lufthansa is cutting some services this quarter and next.

In Spain, truckers have begun to notice a slight slowdown in demand in the past several months from clients in France and Germany, bucking four years of solid annual growth, said Juan Jose Gil, head of Fenadismer, an association that represents 32,000 small Spanish transport companies.

“Germany is Europe’s locomotive,” Gil said. “If Germany catches a cold, other countries get sick.”

The euro-area economy is already feeling some pain. Annual growth stayed at the weakest in more than four years in the first quarter. Expansion for all of 2019 is predicted to come in at 1.2%, less than half the pace predicted for the U.S.

Contagion might not materialize. Some point to Germany’s specific issues, such as exposure to global trade and in particular cars. The U.S. has made autos a key target of its tariffs, adding to structural issues such as the transition to electric vehicles.

“The people who see the glass half full would say the manufacturing slowdown is a pretty atypical one rooted in trade and uncertainty,” said William De Vijlder, chief economist at BNP Paribas. “It’s not a reflection of a collapse of domestic demand.”

That domestic demand is being supported by the labor market, often cited by ECB policy makers when pushing a more optimistic view. Employment has grown for 23 straight quarters, and the jobless rate has fallen to the lowest in more than a decade.

“We have strong labor markets, higher wages, good private consumption, but at the same time we have these clouds of uncertainty,” said Carsten Brzeski, an economist at ING in Frankfurt. “The ECB is ready to act and it will only need a very small or minor economic accident.”