A Quick Lesson Hidden in the Eurozone’s Double Dip

After its Q1 GDP slip, the eurozone fell into a “double-dip” recession, i.e., when GDP contracts for at least two consecutive quarters following a short-lived recovery from an earlier recession. The GDP dip was widely expected, but it also seems to defy widely watched business surveys. However, seemingly contradictory datasets aren’t strange once you look under the hood—a big reason why we think digging into the data can be worthwhile for investors.

Of the eurozone’s four largest economies, only France (0.4% q/q) grew in Q1.^[i] Italy (-0.4% q/q), Spain (-0.5% q/q) and Germany (-1.7% q/q) contracted, contributing to the eurozone’s -0.6% q/q decline.^[ii] The results didn’t surprise experts, many of whom rationally noted that ongoing lockdowns drove down eurozone output in the quarter. See Germany, where COVID restrictions persisted in Q1 and may linger until the end of May or mid-June. That is a stark contrast with America, where states began easing restrictions in early March.

Astute data observers may notice a seeming contradiction in this contraction: Why was GDP so weak even as business surveys reported growth? Take Germany, whose IHS Markit Composite Purchasing Managers’ Index (PMI) registered 50.8, 51.0, and 57.3 in January, February and March, respectively.^[iii] A Composite PMI combines output from both the services and manufacturing sectors, and readings above 50 imply expansion. Yet German GDP’s quarterly decline was sharpest among major eurozone economies.

However, these data aren’t in conflict—they just measure different things. PMIs are business surveys reflecting private sector activity. They are a timely snapshot of general business conditions—i.e., whether respondents see more economic activity or less in a given month—but they don’t measure the magnitude of that activity. GDP, in contrast, is a government-produced gauge of broad economic output. It tracks inputs including personal consumption, private investment, government spending and trade—and the magnitude by which those components grew or contracted in a given time period. GDP is a comprehensive attempt to track how a nation or region’s broad “economy” is faring, though it has imperfections. For example, GDP treats government spending as always and everywhere growth-positive—not necessarily the case, as public spending and investment can crowd out private activity, which may not be a net positive.

In the case of Germany’s Q1 numbers, the composite PMI reflected record-setting manufacturing activity that overshadowed a subdued services sector.

Exhibit 1: Q1 German PMIs

Source: FactSet, as of 5/4/2021. Readings above 50 imply expansion.

As IHS Markit Associate Economics Director Phil Smith noted:

The German Manufacturing PMI marked its 25^th anniversary in March with a record-high reading of 66.6, showing the goods-producing sector going from strength to strength. It was a record-breaking month on many fronts including new export orders, which have benefited from synchronised upturns in sales to the US and China and seen an unprecedented number of German manufacturers reporting growth.^[iv]

However, Germany’s Services PMI returned to expansion only in March, and only barely, as lockdown measures hindered businesses—relevant to Q1 GDP’s weak showing. Despite Germany’s reputation as an industrial powerhouse, manufacturing’s share of GDP is roughly 20%.^[v] Services comprise 70%—much more influential on GDP’s direction.^[vi] COVID restrictions disproportionately impact services businesses, many of which are people-facing. In contrast, outside of last year’s initial lockdowns, German factories remained operational when subsequent COVID waves triggered new restrictions. Alongside other temporary developments—e.g., weak household consumption may have also reflected the expiration of a temporary value-added tax (VAT) cut that pulled spending into Q4 2020—Germany’s GDP contraction isn’t a shock.

While GDP and PMIs receive plenty of attention when released, markets see through all the associated chatter and analysis, as they have already digested the information. GDP covered January, February and March. We are now in May. Even preliminary or “flash” PMIs, which preview the final figures, reflect responses from several weeks prior. These data therefore confirm a reality stocks have already priced in. Stocks are forward-looking, which means they focus on the future—specifically the next 3 – 30 months, in our view. What matters most from here is how investors’ expectations align with reality. With vaccines finally rolling out across the Continent, we expect the eurozone economic recovery to soon follow the general path of other major economies, including China, America and the UK, and that likely means a brief growth-rate pop before a return to pre-COVID growth trends—worth keeping in mind now, especially as pundits become more optimistic about growth ahead.