The composite PMI declined 0.8pts to 45.9 in May and is now down 4.5pts since January. Composite new orders declined a bit less (0.4pts) but to a similarly low 44.5. Only the composite employment index nudged up to 48.3. Input price pressures eased a bit, while the output price index remained below its average. By sector, the output index fell 1.5pts in manufacturing to 44.7 and 0.4pts to 46.5 in services. New orders were roughly unchanged at 45.3 in services and they declined another point in manufacturing to just 42.5. The inventory indices rose a bit in manufacturing so that their ratio with new orders deteriorated a bit further. By country, the composite PMI fell 0.9pts to 49.6 in Germany and 1.2pts to 44.7 in France, while means that the rest of the region fell around 0.5pts to 42.7. Germany is still holding up better in a relative sense; its services PMI remained elevated at 52.2 but the output index in its manufacturing PMI dropped sharply to 44.6 (in January it was almost 10pts higher at 54.3).
Given the PMIs so far in 2Q12, we now think that Euro area GDP will decline 1.2%q/q saar in 2Q, rather than the 0.8%q/q saar that we had pencilled in so far. The bigger question is about the subsequent quarters. The PMI's decline since January could reflect some transitory factors, such as the lagged impact of the credit tightening in 4Q11 and the fiscal tightening (the impact of which may be most intense in 2Q). But, the uncertainties and stresses in the Euro area are also taking their toll on domestic demand. This is more worrying given that the stresses are likely to persist for a few more weeks at least (e.g. the Greek election is still 3 weeks away). Hence, we have also decided to revise down our forecast for 3Q12 from -0.5%q/q saar to -1.0%q/q saar and for 4Q12 from +0.3%q/q saar to 0.0%q/q saar. This implies a full-year forecast of -0.4%oya for 2012.
The mild recession that the ECB had been expecting was supposed to be ending around now and be followed by a gradual recovery in 2H12. Today's PMI is challenging this view and we think the ECB will feel more pressure to deliver a monetary response, even though it feels that is has already done a lot to support the region. This response could for example be done through interest rate cuts or through further liquidity measures (e.g. 1-year LTROs). Given that the ECB has viewed the latter as a quasi-monetary policy tool, rather than as exclusively a way of dealing with financial market stress, there is some substitutability between these tools in the ECB's mind. This makes the mix between them and the exact timing hard to call.
We suspect the ECB's first response will be in terms of new liquidity measures. The committment to supply unlimited liquidity at the regular refis (1-week, 1-month and 3-month) expires in mid-July and an extension of this should be announced at the June meeting. Whether the ECB will also announce some LTROs (likely of maturites up to one year) at the June meeting is less clear. Its latest commentary suggested that it is not minded to move this early and that it will wait instead for the outcome of an internal review that it is conducting about the effectiveness of its policy tools so far. Waiting until July would also give the ECB a better sense of the political situation in Greece after the election. Hence, we pencil in the announcement of 1-year LTROs for the July meeting. Beyond this we expect the main refi rate to be cut 25bp at the September meeting, with the deposit facility rate remaining at 0.25%. This implies that the ECB will respond very incrementally to the current macroeconomic weakness.