Euro zone rebound hopes dashed by services slump

By Balazs Koranyi and Jonathan Cable

FRANKFURT/LONDON (Reuters) -The euro zone economy is still just limping along and a raft of surveys published on Thursday point to only lukewarm optimism among firms as services, the bloc's engine in the past, also appear surprisingly weak.

Europe's growth has trailed global peers, particularly the U.S., since the pandemic and predictions for a rebound have been proven wrong time and again as firms hold back investment, households sit of savings and governments fail to enact the sort of structural policies that would reduce inefficiency.

The closely watched composite HCOB Purchasing Managers' Index for the bloc dropped to 49.5 in May from April's 50.4, dropping below the 50 mark separating growth from contraction and falling short of the 50.7 expectation a Reuters poll of economists.

The figure is especially worrisome since services, the driver of growth in recent years, was the main culprit in the decline, although economists cautioned against reaching firm conclusions since the noise generated by rapidly shifting U.S. trade policy was a key factor.

"The trade war is weighing on the euro zone economy, but likely mostly through the uncertainty channel rather than direct trade effects so far," ING economist Bert Colijn said.

"Sluggishness remains the name of the game for euro zone economic activity, and risks seem to be to the downside for the short term as the trade war could intensify," Colijn added.

While even HCOB acknowledged that figures were weak, it said there was modest good news in the outlook.

"There are reasons for confidence in the longer term," HCOB chief economist Cyrus de la Rubia, said. "The recovery in manufacturing is broad-based, with encouraging signs coming out of both Germany and France."

"Germany, in particular, might be gearing up to reclaim its role as the euro zone’s economic engine, thanks to a potentially very expansionary fiscal policy," he said.

Germany plans an historic spending package, aimed at boosting defence and investing in infrastructure.

Signalling heightened expectations for the new German government, the Ifo Institute's monthly sentiment indicator rose a touch more than predicted this month and expectations rose sharply in both wholesale and retail trade.

"The German economy is slowly regaining its footing," Ifo President Clemens Fuest said.

ECB RATE CUTS

Economists added that the European Central Bank's seven interest rates cuts in the past year were also propping up sentiment and reducing cost, especially since the bank is still not done easing and a few more steps are likely.

"The fifth consecutive increase in the Ifo business climate index shows that German companies defied Trump's tariff shock also in May," Commerzbank economist Joerg Kraemer said. "Apparently, the positive effects of the ECB's rate cuts outweigh the higher tariffs."

Still, economists said the lukewarm readings on current business conditions combined with only a modestly optimistic outlook add up to tepid growth, fraught with downside risks.

The ECB and the European Commission both see the euro zone growing by less than 1% this year, much like last year, and see risks tilted to more negative outcomes, especially if the trade war intensifies.

"We think that uncertainty will continue to drive a negative momentum in the PMI figures, at least until the US and EU sign a (trade) deal," Christophe Boucher at ABN AMRO Investment Solutions said.

(Reporting by Balazs Koranyi, Jonathan Cable and Rachel More; Editing by Toby Chopra)