Compared to the gloomy forecasts at the nadir of the energy crisis last winter, recent months have seen widespread upward revisions to growth forecasts, particularly for the UK, which now looks set to avoid recession in the first half of 2023. The Eurozone, too, has fared less badly than predicted albeit growth remains anaemic and revised data show that Germany has now entered a recession in Q1 of this year. However, a closer examination of various high-frequency indicators reveals a concerning trend emerging among the world’s most advanced economies.
Since the beginning of the year, growth has increasingly been driven by the services sector while manufacturing is faring much worse. In the UK, this observation is reinforced by the latest BDO Business Trends data, developed in collaboration with Cebr.[1] The Services Output Index reached an eight-month high in April at 99.80.[2] Meanwhile, the Manufacturing Output Index remained deeply negative at 82.94, marking its worst performance since the early stages of the pandemic nearly three years ago. Similarly, the Services Optimism Index exhibited a positive trend, reaching its strongest reading since August 2022 at 98.22. Conversely, optimism in the manufacturing sector fell to its lowest level since February 2021.
A similar picture emerges when looking at the US and Eurozone, with PMI readings consistently placing the services sector in expansionary territory since February. In contrast, manufacturing PMIs have mostly remained in contractionary territory and have generally shown a downward trend.
Figure 1: Manufacturing and Services PMI by market economy
Source: Macrobond
While both sectors are affected by the same economic headwinds, such as elevated energy prices, supply chain disruptions, tighter monetary conditions, and partial labour shortages, their diverging performances reveal the degree with which businesses are able to deal with these challenges.
Several factors contribute to this disparity. Manufacturing heavily relies on capital machinery and equipment – debt financing for investments for new machinery and/or maintenance has been made substantially more expensive by the high interest rate environment. Moreover, while some may view the easing producer price inflation, now in single-digit territory in the UK, US, and Eurozone, as a sign of relief for manufacturers, the fact remains that although input inflation has eased, input prices still remain historically high. A similar argument can be made for energy prices, which are a key consideration in industries such as chemicals or steel making. This is likely to continue weighing on the sector’s performance until a decline in input prices, in other words, annual deflation in producer prices, is observed.
There have been encouraging indications of a gradual alleviation in supply-chain bottlenecks over the past few months. The latest reading on the GEP Global Supply Chain Volatility Index has reached negative territory, marking the first time in nearly three years that the supply chain has been underutilised and indicating a shift towards a buyers’ market.[3] This outcome was anticipated, given China’s complete reopening and its consequential effects on global supply chains.
However, despite this positive development, global demand remains subdued, and the expectations of a significant rebound in global activity following China’s reopening have diminished due to mixed signals regarding its ongoing recovery. These findings align with our earlier analysis in February, where we examined China’s outlook post-reopening and predicted that its recovery would have limited impact on global growth.[4] Consequently, this presents a challenging scenario for the manufacturing sector, as the global downturn is expected to dampen activity within the sector in the upcoming months.
Looking at the services sector, the pandemic seems to have significantly impacted consumption habits with consumers willing to pay higher prices to socialise, go on vacation and ‘catch-up’ on other experiences, despite higher prices. In essence, changing priorities and a preference for experiences have resulted in reduced demand for manufactured goods, while the services sector thrives.
The robust performance of the services sector in the early stages of 2023 is a welcome sign of resilience, especially as weakness in the manufacturing sector is unlikely to subside soon. Nevertheless, it is important to acknowledge the potential challenges that accompany this strong performance. The persistently high levels of services inflation, a critical gauge of domestic price pressure, are monitored closely by central banks. Elevated rates of core inflation likely mean that the Bank of England and the European Central Bank still have some way to go in their tightening campaigns, while opinion at the Federal Reserve currently seems to be split on whether or not rates have peaked. Crucially, a lot of the impacts of tighter monetary policy are yet to be felt by consumers who have seen their disposable incomes eroded over the past year by the spike in household bills. This is especially true for mortgage holders who are rolling off their fixed term contracts this year and need to adjust to significantly higher rates, with estimates from the Office for National Statistics suggesting that approximately 700,000 mortgages will need refixing in H2 2023 alone.[5] As the cost-of-living crisis drags on, there is a risk that consumers might reach a point where they are no longer willing or able to pay the higher prices demanded by service sector businesses such as restaurants and hotels. Should consumers react more vigorously than anticipated, there is a risk of a simultaneous downturn in both the services and manufacturing sectors, reigniting fears of a potential recession.
[2] A score of 100 signifies average trend growth; scores greater than 95 signify positive growth.
[3] GEP Global Supply Chain Volatility Index
For more information, please contact:
Kay Daniel Neufeld, Director and Head of Forecasting and Thought Leadership
Email: kneufeld@cebr.com, Phone: 020 7324 2841
Pushpin Singh, Economist
Email: psingh@cebr.com, Phone: 020 7324 2871
Cebr is an independent London-based economic consultancy specialising in economic impact assessment, macroeconomic forecasting and thought leadership. For more information on this report, or if you are interested in commissioning research with Cebr, please contact us using our enquiries page.