In Europe: Recession, 500-Year Drought

The European economy is in trouble.

I doubt that’s news to anyone. But it was in the news again on Tuesday, courtesy of flash PMI readings for August, which suggested activity contracted again this month.

The manufacturing and composite gauges compiled by S&P Global both printed in contraction territory (figure below). At 49.2, the composite index sat at an 18-month low. The manufacturing gauge, at 49.7, was the lowest since June of 2020.

Although the services index managed to stay above water, 50.2 essentially means activity was flat early this month. “Cost of living pressures sapped demand in the service sector, leaving activity only just inside growth territory,” S&P Global said.

The fresh read on activity came amid a harrowing spiral in power and gas prices, and new 20-year lows for the euro. “The August PMI indicates the economy is heading towards recession quickly if it’s not already in one,” ING’s Bert Colijn said Tuesday. “Weaker demand is leading to some fading of inflationary pressures, but the question is how soaring energy costs will impact this in the coming months.”

That latter point is important. This isn’t as self-correcting as economists sometimes imagine. As long as people still need energy, exogenous shocks like that precipitated by the conflict in Ukraine can overwhelm demand destruction when it comes to price pressures. High prices don’t always “cure” high prices.

“Weaker demand and easing input prices are helping selling price inflation moderate a bit, but the question is whether this can last now that natural gas prices are reaching new records again,” Colijn went on to say.

At the country level, flash PMIs for Germany and France were underwhelming, to put it nicely. The composite gauge for Europe’s largest economy dropped to 47.6, a 26-month low. German services activity contracted for a second month and although the manufacturing PMI touched a two-month high, it was still below the 50 demarcation line. In France, services activity expanded slightly early this month, but the manufacturing gauge hit a 27-month low and the composite index, at 49.8, dipped into contraction territory.

“High inflation and a waning post-COVID boost to demand has led businesses and consumers to cut back on discretionary spending, causing demand for services to fall for the first time since March 2021,” Joe Hayes, Senior Economist at S&P Global Market Intelligence, wrote, editorializing around the French survey. “This was accompanied by another steep decline in manufacturing order books as businesses in both sectors commented on weakening underlying demand conditions and growing client hesitancy.”

“The PMI data paint a bleak picture of the German economy midway through the third quarter,” S&P Global’s Phil Smith remarked, in the color accompanying the German release. “August’s data provided evidence of a further easing of both supply side constraints and cost increases, which helped to lift business confidence from July’s recent low [but] with the threat of an energy crisis still looming large, the outlook remains riddled with uncertainty,” he added.

SocGen analysts including Michel Martinez wrote last week that although their base case doesn’t include “material” energy rationing, the surge in power and gas prices “will likely lead to the temporary closure of manufacturing plants and demand destruction, even if consumers continue to be largely shielded by government measures.” The situation, they conceded, “is highly uncertain” and depends on “whether Russia halts its gas supplies in the coming months, how cold the winter will be, the availability of alternative sources of gas or substitution by oil and coal, etc.”

Meanwhile, a new report from the EU’s Joint Research Center showed that in early August, 47% of Europe experienced drought “warning” conditions and 17% lived under “alert” conditions (figure below).

“The severe drought affecting many regions of Europe since the beginning of the year has been further expanding and worsening as of early August,” the report said, citing a “wide and persistent lack of precipitation combined with a sequence of heatwaves” for the crisis.

The summary went on to note that the “severe precipitation deficit has affected river discharges widely across Europe,” while lower stored water volume has had “severe impacts on the energy sector for both hydropower generation and cooling systems of other power plants.”

At the same time, a lack of water and scorching heat have combined to “substantially reduce summer crop yields.” SocGen estimates that recent droughts could reduce GDP by 0.3pp in the second half.

Apparently, the figures from the European Drought Observatory suggest 2022’s European drought is the worst in “at least” 500 years.

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