Private sector activity in the eurozone unexpectedly shrank in May, signaling a setback in the region’s economic recovery. The latest data showed the Composite Purchasing Managers’ Index (PMI) dropping from 50.4 in April to 49.5 in May. This figure falls below the critical 50 threshold that separates growth from contraction and marks the lowest reading since November 2024.

Economists had anticipated a slight expansion with forecasts around 50.7, but the decline points to renewed economic challenges. A reading below 50 generally signals a shrinking economy, sparking concerns among investors and policymakers about the eurozone’s short-term prospects.

Services Sector Takes the Biggest Hit

The services sector, which makes up a large portion of the eurozone economy, suffered its sharpest decline since January 2024. The services PMI fell sharply to 48.9 from 50.1 in April. This downturn suggests that consumer and business spending on services like hospitality, retail, and finance weakened noticeably in May.

Meanwhile, the manufacturing sector saw a slight improvement but remained below the growth line. The manufacturing PMI edged up to 48.4 from previous months but stayed under the 50 mark. This shows factories and industrial output still face headwinds despite a small recovery.

Business confidence in the eurozone continued to weaken, extending its downward trend for a second straight month. Confidence in the services sector reached its lowest point since September 2022. These signs of uncertainty reflect worries about future demand and economic conditions across the region.

Economists Point to Weak Demand as Key Factor

Economists say weak demand, both at home and abroad, is the main driver behind the slowdown. Cyrus de la Rubia, an economist at Hamburg Commercial Bank, described the eurozone economy as “stagnant.” He noted that the Composite PMI has barely indicated growth since January and that in May, the private sector slipped back into contraction.

De la Rubia dismissed the idea that recent U.S. tariffs were to blame for the eurozone’s weakness. Instead, he suggested that some industries might have pulled activity forward earlier in the year, making May look weaker by comparison.

He pointed out that eurozone manufacturers managed to increase production for the third consecutive month. New orders stabilized for the first time since April 2022, showing some signs of recovery in factory activity. However, weak domestic demand heavily affected the services sector, pulling the overall PMI down.

“Foreign demand softened, but domestic weakness pulled the sector down,” de la Rubia explained.

Inflation and Costs Keep Pressure on Services

Despite falling energy prices, rising wages are pushing up costs in the service sector. While sales price inflation has eased slightly, the cost of inputs like labor and materials continues to climb. This mix makes it difficult for many businesses to boost profits or increase hiring.

Given these pressures, de la Rubia expects the European Central Bank (ECB) to be cautious with future interest rate cuts. Slowing inflation in some areas may give the ECB room to ease monetary policy gradually, but rising wage pressures remain a concern.

Germany and France Show Different Economic Paths

Within the eurozone, economic conditions vary. Germany, Europe’s largest economy, saw business activity fall further in May. The Composite PMI dropped to 48.6 from 50.1 in April, signaling contraction.

Germany’s manufacturing sector showed modest improvement with a PMI of 48.8, indicating continued struggles but some resilience. However, the services sector saw a steep decline, dropping to 47.2 and dragging the overall index lower.

“Manufacturing has grown for three months, but the steep decline in services tipped the economy into contraction,” said de la Rubia. He noted hopes that government spending on infrastructure and defense might help revive growth. Additionally, lower energy prices could give manufacturers some breathing room.

France painted a slightly brighter but still weak picture. The Composite PMI rose slightly to 48.0 from 47.8. Manufacturing in France reached 49.5, its best level since February 2023, showing tentative signs of recovery.

However, France’s services sector remained weak at 47.4, holding back the overall economic outlook. Economist Jonas Feldhusen attributed this weakness to political instability and economic uncertainty in the country.

“Manufacturing showed signs of recovery, but services kept sliding,” Feldhusen said. He warned that falling prices and rising costs are squeezing profit margins for many companies.

Markets React Calmly to PMI Data

Despite the disappointing PMI figures, financial markets showed a relatively calm response. The euro remained stable against the U.S. dollar, trading at around $1.1330 early in the European trading session, unchanged from the previous day.

Skepticism about the strength of the U.S. dollar helped support the euro’s resilience. German government bond yields also showed little movement. The 10-year yield held steady at 2.65%, while the 2-year yield dipped slightly to 1.83%. Market participants largely expect the ECB to continue its cautious approach to interest rate cuts.

Equity markets, however, declined across the eurozone. The Euro STOXX 50 index fell 1.4%, with most stocks losing ground. Germany’s DAX and France’s CAC 40 both dropped by 0.7%. Italy’s FTSE MIB slid 0.9%, while Spain’s IBEX 35 declined by 0.7%.

What This Means for the Eurozone Economy

The latest PMI data highlights the eurozone’s ongoing struggle to maintain steady economic growth amid mixed signals. While manufacturing shows some resilience, the services sector’s weakness and falling business confidence pose risks to the region’s recovery.

Economic experts warn that weak domestic demand and inflationary pressures could slow progress. At the same time, geopolitical tensions and political uncertainties in member countries add to the cautious mood.

The European Central Bank faces a delicate balancing act as it seeks to manage inflation while supporting growth. The current data suggests a slow and cautious approach will continue in the coming months.