Germany’s business outlook worsened for the first time in five months - a sign that the gradual recovery in Europe’s biggest economy faces headwinds.

An expectations gauge by the Ifo Institute fell to 89 in June from 90.3 in the previous months - defying analyst predictions for an improvement. A measure of current conditions held steady.

“It’s a setback,” Ifo Institute president Clemens Fuest said on Monday on Bloomberg Radio. “We’ve seen some improvements in recent months, but now this seems to have stopped. The negative data we’re seeing is coming in particular from manufacturing.”

The reading highlights the challenge in moving past the recent years’ economic malaise, with consumers remaining hesitant despite rising incomes and cooling inflation. Output expanded 0.2% in the first quarter, helped in part by mild weather. The Bundesbank said last week that growth is set to continue in the three months through June.

In the country’s large manufacturing sector, firms “are now telling us that the order backlog is a problem”, Fuest said. He also pointed to “bad data from retail”, which signalled that the expected rebound in consumption on the back of rising wages is “just not happening”. 

“The drop in the June readings of Ifo business climate index and PMI [Purchasing Managers Index] suggest that the recovery of the German economy might be bumpier than it seemed a few weeks ago. This is mainly due to a grimmer outlook for the industrial sector, while activity in the service sector is likely to gain more momentum,” said Bloomberg Economics economist Martin Ademmer.  

Bright spots were visible in services, where the outlook for the second half of the year continued to brighten. Sentiment improved especially in the hotel sector.

There have been other indications that any recovery won’t be strong. Business surveys by S&P Global last week showed momentum softening due to weaker industrial output. Investor expectations also improved less than economists had anticipated.

Subdued foreign demand and high borrowing costs are a major obstacle for Germany’s manufacturing sector, which has lagged behind services in recent months. The threat of greater trade tensions with China is an additional worry.

“Automotive companies are concerned about the prospect of tariff war with China, but it’s also a domestic problem,” according to Fuest. “We’ve been seeing reluctance of companies in Germany to invest domestically, and the investment-goods industry suffers from that and sees declining orders.”

While monetary easing by the European Central Bank should help reverse that development, officials have made clear that they’ll be cautious in lowering borrowing costs. Investors only expect between one and two further cuts this year.

  - Bloomberg