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The Decisive Episode 18: Made in Europe

Kristen Hallam   00:00:00

Welcome to the Decisive podcast brought to you by S&P Global Market Intelligence. I'm your host, Kristen Hallam. And in this episode, we're exploring the constraints on the European Union's industrial sector and the potential for an industrial up cycle. To delve into this topic, I'm joined by David Vagenknecht, Emerging European Economist; and Shuchita Shukla, Senior Economist, both from the Market Intelligence European Economics team. Welcome, David and Shuchita. All right. Let's start by hopping into the time machine that we have here at The Decisive, but you didn't know that we had one, but we do. And let's go back to 2022. That's when the final pandemic-related restrictions on businesses were lifted in Europe, and that is also when the Russia-Ukraine war began. What bottlenecks did we see on the supply side after that? And how have they progressed since?

Shuchita Shukla   00:01:20

So the European Commission conducts a quarterly survey on limits to production in the European Union. And looking back into 2022, the industrial sector responses to the survey were consistently flagging supply side bottlenecks at the time, either in the form of labor shortages or high production costs or insufficient raw materials. What this really is saying is that in this period of post-pandemic time, pent-up demand was, of course, quick to snap back, but scaling back supply was more challenging, especially with the breakout of the war in Ukraine, which majorly disrupted European supply chains and sent producer prices soaring. As we return to the present, these same surveys are telling us that the supply side constraints are still more limiting for production now than over the pre-pandemic period on average, but they have continued to ease through the first half of 2024. Commodity price inflation has moderated, and this includes energy prices. Material shortages have gradually diminished. -- suppliers' delivery times have shortened and vacancy rates have fallen or if not normalized. More recently, some supply side headaches have returned, not least from the intensification of geopolitical conflicts, especially in the Red Sea, but their adverse impact on European supply chains has so far been limited. So although the supply side may not be back to normal just yet in Europe, -- the improvements so far have been notable and importantly, sufficient to incentivize the firms to execute some of their previously postponed capital expenditure, leading to improved production capacity at present compared with 2022.

Kristen Hallam   00:03:10

Supply side headaches, I like that imagery there. So given all of that, Shu, what were our expectations for European manufacturing coming into 2024?

Shuchita Shukla   00:03:22

Yes. So based on this improving supply side context in Europe that I just talked about, we were expecting a manufacturing upturn to begin over the second half of 2024. Our view was reinforced by our leading euro area PMIs, which showed an easing rate of decline for manufacturing output index through May as it approached stabilization. But as we are talking now in October, we, of course, know that things have progressed differently with no upturn in sight and the Eurozone manufacturing PMI sliding deeper into contraction at the end of the third quarter.

Kristen Hallam   00:04:01

What happened to shift our expectations for 2024?

Shuchita Shukla   00:04:07

In short, the demand has disappointed. In fact, Euro area manufacturing PMI has been pulled down by a steepening rate of declining new orders and insufficient demand has also emerged as an increasingly limiting factor for production in the European Commission's survey bucking the trend of improvements in all of the factors that we've just talked about. The latest PMI readings for September show that the export orders are declining faster than output, which means that the European industries are currently relying on backlogs of work to sustain production, but prolonging this reliance is unviable for the industries as the stocks of pending orders are depleting fast. So putting it all together, not only is the supply side more constraining now than it has broadly been in the pre-pandemic past, there also just isn't much demand for goods made in Europe right now.

Kristen Hallam   00:05:04

And yet some of my favorite goods are made in Europe. But let's look into that. What kinds of manufacturing goods are we talking about here? David, let's bring you in to talk about that.

David Vagenknecht   00:05:14

I think, first of all, generally, you can say that there is weakness rather broad-based in the industrial production in Europe going on right now. But looking at specific goods is especially pronounced in sectors skewed towards heavy goods that are tied to the weak global CapEx cycle. And talking about heavy goods, what you can picture in mind, these are typically products and materials that are large in size or heavy in weight or products that involve complex manufacturing processes. For instance, machinery used in construction comes to mind or also Europe's famous car industry is a good example as well.

Kristen Hallam   00:05:54

So why is demand for these goods weak, David?

David Vagenknecht   00:05:57

Let me draw a parallel here first. So let's focus on the services sector for a second. The services sector has been performing relatively well lately. And this is because of recovering consumer spending as real incomes are gradually restored now that wage growth is more or less catching up with the recent past inflation surge. Now in contrast, going to the industrial sector, especially when talking about these heavy goods, it's less about consumer spending and more about business spending. A family wouldn't buy construction machinery, but a business would. But at the moment, business investment or business spending is still subdued, and that's to a wide range of factors. This includes still elevated interest rates or uncertain economic outlook clouded by geopolitical tensions, but also these growing concerns about global protectionism.

Kristen Hallam   00:06:55

Are there particular corners of the EU where this weak external demand for goods is more pronounced, David? For example, if we were looking at a map of the EU, which countries would light up?

David Vagenknecht   00:07:07

If you were looking at a map of Europe, you would see mostly the northern part of Europe flashing in red, especially Germany because if you look at Germany, almost every incoming piece of data is pointing to ongoing weakness in industrial orders. And the question is why that is the case. And it's the reasons I've provided before, but also we link this weakness in Germany to its reliance on Chinese and U.S. markets. And then since Germany is an important export market for a variety of EU countries, like the Visegrad countries, which include Czechia, Slovakia, Hungary, Poland and by extension also Romania, this weakness in Germany is then holding back the upturn in the EU's industrial cycle as a whole. To give you a sense of the dependencies on Germany, so for example, 30% of Czech and Polish exports are shipped to Germany. And both Czechia and Poland have a high share of specialized intermediates goods. exports. That is exports that are tailor-made for a particular customer. So then if you think about this specificity in these exports, it cuts down on flexibility in terms of being able to redirect from your German customer to someone else.

Kristen Hallam   00:08:22

So what is our near-term outlook for Europe's industrial sector then?

Shuchita Shukla   00:08:28

The simple answer is that we expect industrial production to move sideways over the remainder of 2024 with risk skewed to the downside should export orders in Europe decline further going into 2025. And as we mentioned before, relying on backlogs of work to sustain production is not viable for a prolonged period. So a confident external demand recovery must follow the improvements in production capacities that we've seen so far for an industrial up cycle to begin in Europe. the real detailed answer is that within the broad industrial sector in Europe, we are likely to see varied performance along the main verticals. Isn't that right, David?

David Vagenknecht   00:09:16

Yes, you're right. That's the picture we're likely going to witness going forward. The somewhat improved conditions in the supply side since the COVID-19 pandemic are now being contrasted with renewed supply chain headwinds, and this is all coupled with still weak demand. In short, this is a very specific environment to be in as a company. And it's more difficult for some industries than for others. And this is because every industry reacts differently to this nuanced situation. For instance, industries that rely on ongoing inflows of new orders and operate on just-in-time deliveries are more at risks. These sectors include the fast-moving consumer goods sector like textiles, consumer electronics or even food, although regarding food, many products classify as essential, meaning that they are less sensitive to swings in demand as people still need to buy food regardless, but still these sort of industries are at risk. And since we also touched upon the automotive sector at the start, let me briefly mention this one as well. The car industry has in the last, let's say, several months, benefited from backlogs of work with producers working through past orders. But looking at recent data, it shows that this buffer from these backlogs of work is getting thinner, making future production gains in the automotive sector quite uncertain.

Kristen Hallam   00:10:45

Let's look further out. What are some of the structural factors that are likely to influence the EU's cyclical manufacturing upturn?

Shuchita Shukla   00:10:56

That is a very interesting question, Kristen. And David and I have done a lot of thinking around this for our recently published report, building on research from other parts of our global economic service. Overall, we think that recent structural shifts in Europe do not support a cyclical outperformance for its industries in the near future, especially when comparing with previous periods of recovery. So a key shift that we mentioned in our report is that the era of cheap gas is over for the European Union. Piped gas imports from Russia are already 80% lower than the past 5 years. and are planned to be phased out entirely by 2027. There are various replacement efforts ongoing, including increasing the share of renewables in the energy mix and bringing in more seaborne LNG shipments or even initiating piped gas deliveries from Azerbaijan, but all of these avenues are subject to great uncertainty about the costs and the volumes involved. And in some cases, they also rely on complex multiparty alignment of very great political sensitivity. A second constraint that we see is our below trend GDP projections for the U.S., which erode export demand from the EU's largest trade partner over the coming years. The upcoming elections there are relevant for the country's trade policy going forward. And should an increase in import tariffs materialize, we are likely to see increased degree of import substitution in the U.S., which would, of course, structurally reduce demand for EU origin goods. When talking about the structural landscape, we, of course, cannot forget about the EU's competitiveness on the global scale. David, do you want to add anything on that?

David Vagenknecht   00:12:51

I would raise the position of China in the global supply chain, which is increasingly relevant from a European perspective. Looking at Mainland China, it currently boasts excess production capacity and over the years of its supply-driven growth model, its export basket has restructured in favor of product groups that make up most of the EU's exports to the rest of the world. This includes products such as machinery and equipment, also some midstream and raw material sectors, including auto parts, chemical products or even plastics and rubber. So there is definitely a growing competition for the EU industrial sector going ahead.

Kristen Hallam   00:13:33

It's time to wrap up our discussion. Any final thoughts for our listeners? David, since you've got the mic, so to speak, let's start with you.

David Vagenknecht   00:13:45

We will continue to operate in a quite volatile environment where a couple of months from now still feels like a million years. So I would say expect the unexpected. But to give you some actionable view as well, I'd say don't take individual monthly readings of industrial production as a confirmation of your view, whatever that might be because under the hood of headline industrial production numbers lies this varied response across sectors. For example, in 1 month, you might see a decline in overall production as a result of, let's say, falling car production, which might be due to some specific supply chain issue. Now this issue might then be cleared in the following month, driving up car production and so improving the headline number. But we are still stuck in the same loss in demand and production. So until we see an upturn in the cycle, we are likely to remain in this, I would call it, bumpy up and down dynamics.

Kristen Hallam   00:14:44

Bumpy ride. All right. Shu, any final thoughts?

Shuchita Shukla   00:14:48

Yes. All I'll say is, like David mentioned, we are aim for a bumpy ride, but a cyclical downturn will eventually give way to an upturn even if we must wait for longer. But with so many structural headwinds at play, Europe's ensuing manufacturing recovery is likely to disappoint any expectations of a strong snapback. We think that the path ahead is a ride up, which is slow and hopefully, it will be steady.

Kristen Hallam   00:15:17

All right. Thank you both so much for sharing your insights with us today. Thank you for listening to The Decisive podcast from S&P Global Market Intelligence.