There is an unusually wide gap between manufacturing and services activity in the Eurozone and history suggests large divergences rarely persist long. So will manufacturing weakness spill over into services? Or will a confident trade and investment climate lift industrial production?

Put simply, are we near an inflection point – or an infection point?

Manufacturing needn’t inevitably lead the service sector down. The positive relationship evident before the financial crisis has now broken. In a downswing the relationship should depend on the underlying cause. Europe’s current slowdown results from weaker trade, and the Asia crisis showed that a short, sharp trade shock can be shrugged off without dragging down services.

Today’s question is whether the latest trade disruption will be more persistent and eventually infect other parts of the economy.

Perhaps the most compelling argument against infection is the labour market’s resilience. Robust wage growth is underpinning consumer spending.

Despite tentative signs of recovery, industry is not out of the woods, with export-oriented Germany most at risk. An almost 9 per cent plunge in German industrial goods orders since 2018 threatens investment.

Firms may have hoarded labour, but that gets harder to do the longer uncertainty about global trade continues. And if Europe is experiencing permanently reduced global demand for products such as cars, that could spread into services with unemployment rising again.

On balance we are not yet at an infection point, but the trade tensions suggest an inflection point is some way off too. We have trimmed our growth expectations for the rest of 2019 and cut next year’s forecast from 1.3 per cent to 1.1 per cent.

But Washington raising tariffs on Chinese imports further could cut 2020 Eurozone growth by at least 0.2 percentage points more, and hiking US auto tariffs to 25 per cent might trim another 0.1 points.

Brexit adds further uncertainty. ‘No deal’ could tip the UK into recession, hit sterling, raise inflation and cause the Bank of England to cut bank rate from 0.75 per cent to 0.1 per cent, add GBP65 billion of quantitative easing, plus GBP15 billion of corporate-bond purchases. It would also push Ireland close to recession and disrupt Britain’s other main European trading partners – Germany, France and the Netherlands.

These risks, and stubbornly low inflation, mean the European Central Bank could cut its already-negative deposit rate from -0.4 per cent to -0.6 per cent by December and introduce a ‘tiered’ reserves system easing the squeeze on banks placing large deposits there. It could also announce a restart in its quantitative easing programme.

With few feasible monetary options, including changing inflation targets, fiscal policy could be more potent.

The Eurozone’s fiscal deficit should rise from 0.5 per cent of GDP to 0.9 per cent this year but this is tiny globally; the US deficit could reach 4.5 per cent. However, despite an obvious need for investment, little progress has been made on a Eurozone budget and countries with significant fiscal capacity can’t, or don’t want to, use it.

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