Drivers of recent developments in expectations for business activity across sectors

Created by Niccolo Battistini and Pedro Neves

Published as part of the ECB Economic Bulletin, issue 7/2023.

Expectations for business activity have worsened since mid-2022, with the decline occurring faster than the slowdown in economic growth in the euro area. According to the European Commission's Economic Survey, short-term expectations for business activity have declined year-on-year since the third quarter of 2022. This deterioration foreshadows a subsequent slowdown in euro area economic activity, but the pace of slowdown varies across sectors. This box analyzes a new bottom-up composite index of business activity expectations across sectors. We also use disaggregated data on output expectations and limitations from the European Commission's Business Survey to assess the role played by structural factors in the index.

A bottom-up composite index of business activity expectations is a good leading indicator of real GDP. The index is calculated as a weighted average of the balance of responses to surveys about three-month ahead production forecasts for manufacturing, three-month ahead demand forecasts for services, and short-term forecasts of activity in three key sectors: Masu. This is a purchase order for construction work.^[1] The composite index, measured in the first month of each quarter, is similar to broader indexes such as the European Commission's Economic Sentiment Index and S&P Global's Purchasing Managers' Index, and is based on the year-over-year growth rate of real GDP for the same quarter. There is a strong correlation with Composite output (Table A).^[2] At the sector level, each component also has strong correlations with sector value added data, and the correlations are similar to those shown in Table A.

We use an empirical model to assess the impact of structural factors on business activity expectations. Bayesian structural vector autoregressive (BSVAR) models are estimated for each sector and aggregated to quantify the influence of structural factors on the composite index. The model includes measures of a company's activity and price expectations, as well as perceptions of what factors are limiting production, such as product demand, financial condition, labor shortages, material and equipment shortages, and other factors. contained. (e.g. regulations and, more recently, developments in the pandemic). Using sign and magnitude constraints, identify three demand shocks (product demand, financial conditions, and other demands) and three supply shocks (labor, materials, and other supplies).^[3]

The model shows that recent trends in business activity expectations were driven by a deterioration in demand, but were partially offset by a recovery in supply. During the global financial crisis and the euro area sovereign debt crisis, business expectations declined, primarily due to demand factors (Chart A, panel a). Most recently, it declined in 2020 due to the onset of the pandemic, but recovered in 2021 as the economy reopened (Chart A, Panel b). Again, it was primarily demand factors that drove expectations, with supply factors also playing an important role. However, according to the model, business expectations weakened at the end of 2022, mainly as a result of supply-side forces. This decline in expectations foreshadowed a recent slowdown in real GDP growth momentum. In the year to Q3 2023, business expectations were hampered by weak demand, partially offset by strong supply. The results generated using this model demonstrate the importance of demand factors compared to other studies that found supply factors to play a stronger role in driving business activities, especially in the post-pandemic situation of 2020. is shown. This may reflect different modeling assumptions. Examine the nature of expectations-based metrics or the fact that other studies look at the wider economy than the sectors covered in this box.^[4]

Detailed model-based decomposition suggests that tight financial conditions and weak product demand had the main impact on the forecast for business activity in Q3 2023. On a year-on-year basis, the manufacturing and construction industry's performance expectations for the third quarter of 2023 were significantly worse than the service industry's expectations. This was primarily due to deteriorating financial conditions, which affected all three sectors (Exhibit B). Adversity in product demand also hurt expectations, as the industry continued to reduce inventories. However, it was supported by a recovery in supply (particularly of materials) in manufacturing and construction. It also benefited from good labor supply and other supply factors related to sustained reopening effects in the service sector.^[5]

Deeper analysis across sub-sectors provides more detailed insight into cross-sector developments. Chart C provides an overview of the model-based disaggregation across major industry groups and consumer services, estimated separately from the bottom-up aggregation of the composite index for Q3 2023. All manufacturing groups were affected by tighter financial conditions. On the other hand, the decline in product demand primarily affected intermediate and capital goods (which are more closely linked to investment) rather than consumer goods (which are more closely linked to household final consumption). .^[6] The capital goods subsector was affected by other demand factors, likely related to hurdles related to the green transition of the automotive sector.^[7] Consumer services benefited from a positive labor supply effect, mainly in the accommodation sector, while being negatively affected by delays due to weak material supply, mainly in travel.

Overall, the model provides an assessment of the factors driving sector-wide business activity expectations and an implied path for real GDP growth in the euro area. Improving supply capacity should support activity, but deteriorating financial conditions and declining demand across the industry cloud the outlook for manufacturing in the third quarter of 2023. Looking ahead, the positive reopening effects are gradually waning and the negative impact on economic activity is increasing, despite expectations for more resilient services. Expectations are tilting downward due to tight financial conditions.