Germany in Recession, Business Climate Raises Economic Risk in Euro Area

The final announcement indicates that Germany’s GDP fell by 0.3 percent quarter-on-quarter (-0.5 percent year-on-year) in the first quarter after a decline of 0.5 percent in the last quarter of 2022, thus the economy has indeed entered a recession.

At the same time, the decline in personal consumption (-1.2 percent quarter-on-quarter) has negated the recovery of construction activities and investments in equipment and facilities. Meanwhile, the main business climate indices (PMI indices of purchasing managers, IFO) for the euro area in May, as well as factory orders for Germany, send conflicting signals and do not inspire confidence, according to HUP’s weekly analysis.

After a slight decline, the PMI index for the services sector, as the most reliable business barometer for the euro area, remains close to a high of 56 points, which is significantly above the level of 50 points, above which (historically) a decline in economic activities is not expected. Accordingly, it is expected that the annual GDP growth rate in the euro area in the second quarter could be slightly above the expected growth of 1.5 percent year-on-year in the first quarter. At the same time, a further strong decline in the PMI index for the manufacturing sector below 50 points indicates a recession in the mentioned sector.

The German IFO business climate index also provides unfavorable signals regarding the strong decline in economic expectations over a 6-month horizon, particularly in the manufacturing industry and trade. Moreover, the IFO survey has made it evident that the main stimulus for the growth of the manufacturing industry – the high level of unfulfilled orders accumulated during the pandemic – is increasingly losing significance.

All of the above points to a strengthening of negative risks to GDP growth in the second half of the year. Contrary to the expectation of most that the decline in energy prices will have a beneficial impact on the economy in the second half of the year, we consider it incredible that domestic demand will remain immune to the strong cumulative increase in benchmark interest rates of 375 basis points since last summer.

Given that all major central banks have also significantly tightened financing conditions, it is difficult to hope that weak domestic demand could be compensated by sustainable export growth, especially after the rise of the euro has worsened competitiveness.

Over the last 50 years in Germany, every cycle of rising interest rates has regularly led to a recession with an average lag from the start of raising key interest rates to the onset of recession. Overall, in 2023, we expect a slight growth of the euro area economy of about 0.3 percent along with a decline in German GDP of about 0.3 percent.