German services activity rises to 8-month high despite demand weakness

German service sector activity and the broader composite PMI significantly improved in September, reaching 8-month and 16-month highs respectively, indicating robust output expansion. However, this growth is tempered by continued declines in new business inflows, reduced employment, and rising cost pressures leading to higher prices, raising concerns about the sustainability of the recovery despite service providers' optimism for the year ahead.

Analysis

Germany's services sector demonstrated a surprising rebound in September, with the HCOB Services PMI rising to an eight-month high of 51.5, moving back into expansionary territory. This contributed to the broader Composite PMI reaching a 16-month high of 52.0, suggesting a robust increase in overall output. However, the underlying details of the report paint a more cautious picture, questioning the sustainability of this growth. New business inflows continued to contract for the second consecutive month as clients cut budgets, and the reported activity was largely supported by firms completing existing backlogs of work rather than securing new projects. Most notably, employment in the service sector contracted at its fastest rate since June 2020, a significant negative indicator reflecting firms' response to weakening demand. Furthermore, persistent wage pressures fueled elevated input costs, which were passed on to consumers, pushing services inflation to a four-month high. This presents a mixed and potentially stagflationary environment of headline growth offset by deteriorating demand, falling employment, and rising prices, a concern echoed by Hamburg Commercial Bank's chief economist.

Key Decisions for Investors

• Investors should be cautious of chasing any rally in German or European equities based on the headline PMI figures, as the underlying weakness in new orders and the sharp contraction in employment suggest the recovery's foundation is fragile.
• Monitor upcoming German inflation and wage data, as the report's evidence of persistent cost pressures could compel the European Central Bank to maintain a hawkish policy stance despite weakening forward-looking demand indicators.
• Consider overweighting defensive sectors and underweighting consumer-discretionary names exposed to the German economy, given the clear evidence of falling new business and customer budget cuts.
• The divergence between optimistic business outlooks and deteriorating current data on orders and employment warrants close attention, as a failure for demand to materialize could lead to negative earnings revisions for service-oriented companies.