Iran war drives eurozone into sharpest contraction since 2023 as energy costs surge

Europe's economy is decelerating at a pace not seen since the tail end of 2023 as the war in Iran sends energy costs spiralling, squeezing households and handing the European Central Bank a dilemma it has not faced in this cycle: tightening into a contracting economy.

S&P Global's flash composite Purchasing Managers' Index for the eurozone dropped to 47.5 in May from 48.8 in April, its lowest reading since October 2023 and well below the 50 threshold that separates expansion from contraction. The survey marked the second consecutive month of declining private sector activity. A Reuters poll of economists had predicted no change. The services sector, which accounts for roughly two thirds of eurozone output, led the decline with its PMI falling to 46.4 from 47.6, the sharpest contraction since February 2021.

Energy shock feeds directly into prices and output

The immediate transmission mechanism is visible in the price gauges. Input cost inflation accelerated to a three-and-a-half-year high, while prices charged to customers rose at the fastest pace in 38 months. S&P Global said the data point to headline inflation running close to 4% in the coming months, well above the ECB's 2% target. Eurostat's flash estimate for April already showed annual inflation holding at 3.0%.

Firms across the bloc cited fuel and energy costs as a primary drag. In France, the headline PMI fell to its lowest level in five-and-a-half years. Germany, the largest economy, recorded its second straight month of contraction. The Bundesbank said on Thursday that German inflation is trending upwards and that growth in the second quarter will likely be flat. Outside the single currency area, UK private sector activity suffered its broadest drop in over a year, compounded by domestic political uncertainty.

Gas storage deficit raises supply security fears

The physical tightness in gas markets is acute. Storage caverns and tanks across Europe are just above 35% full, according to Gas Infrastructure Europe data, compared with a seasonal norm of around 50%. Senior executives at Equinor warned on Thursday that a critical shortfall could emerge if shipping through the Strait of Hormuz remains disrupted for another one to three months. Low inventories and distorted pricing have already slowed the stockpiling pace needed ahead of winter.

The Strait of Hormuz handles roughly one fifth of global oil supply and a significant share of liquefied natural gas. Any sustained interruption forces European buyers to bid for alternative cargoes at a premium, feeding through to industrial input costs and household bills. The current storage deficit is the widest for this time of year since the 2022 energy crisis.

Policy response splits between targeted aid and monetary tightening

Governments are resorting to targeted fiscal support rather than broad-based tax cuts. French Budget Minister David Amiel announced an additional €710 million in aid for households and businesses struggling with fuel costs, bringing the total envelope to nearly €1.2 billion. Prime Minister Sébastien Lecornu ruled out a general fuel tax reduction, saying support would stay focused on those most in need. The approach mirrors the playbook used during the 2022, 23 crisis: cushion the blow without blunting the price signal that encourages demand reduction.

Meanwhile, the ECB left rates unchanged at its April meeting but is widely expected to deliver a 25 basis point increase in June. Andrew Kenningham of Capital Economics argued that the PMI data "does nothing to put the ECB Governing Council off its plans to raise rates by 25 basis points in June, nor anything to ease concerns about the risks of a recession." The central bank's own staff projections, updated in March, had not anticipated a supply shock of this magnitude.

Growth forecasts slashed, with worse to come if energy prices persist

The European Commission on Thursday revised its eurozone growth forecast for 2026 down to 0.9% from 1.2% in November, with 2027 growth seen at 1.2% versus 1.4% previously. Economy Commissioner Valdis Dombrovskis cautioned that under an adverse scenario where energy prices do not peak until late 2026, those forecasts would roughly halve, implying growth of around 0.4, 0.5% next year. The Commission's spring forecast assumes the current disruption eases in the second half of 2026.

The downgrade reflects a sharp deterioration in demand. New orders across the eurozone private sector fell at the fastest pace in 18 months, with new export orders dropping at the steepest rate since January 2025. Factory demand, which had risen in April, swung back into decline. Services new business contracted sharply, a signal that consumers are pulling back as real incomes shrink.

Labour market begins to crack

The employment picture is deteriorating in step with output. Eurozone companies cut headcount for a fifth consecutive month in May, with the pace of job losses the steepest since November 2020. Excluding the pandemic, it was the largest monthly reduction since August 2013. Services firms reduced staff for the first time since early 2021, while manufacturing payrolls shrank again. The labour market had been a notable source of resilience through the previous energy shock; its weakening removes a key prop for consumer spending.

The Bundesbank's monthly report, also released Thursday, noted that German firms are increasingly cautious about hiring. The Ifo employment barometer, a leading indicator, has been trending down since the start of the year. In France, INSEE's business climate indicator for services dropped to its lowest since late 2020.

Stagflation echoes but not a repeat of the 1970s

Economists are careful not to overstate the parallel. The 1970s stagflation combined double-digit inflation with deep output losses and a wage-price spiral that took years to break. Today, inflation is lower, central bank credibility is established, and labour markets, while softening, remain tight by historical standards. Wage growth in the eurozone ran at 4.7% in the first quarter, above the ECB's comfort zone but not yet spiralling.

Nonetheless, the combination of contracting activity and accelerating cost pressures is the textbook definition of stagflation, even in a milder form. It strips policymakers of the usual trade-off: raising rates to fight inflation deepens the downturn; pausing risks entrenching price pressures. The ECB's June decision will be a live test of which risk it judges greater.

What happens next

The next flash PMI, due in late June, will show whether May's plunge was the start of a sustained downturn or a shock-driven overshoot. The ECB's Governing Council meets on 18 June; money markets currently price a roughly 80% probability of a 25 basis point hike. European leaders meet for a summit on 26, 27 June where energy security and competitiveness are on the agenda. Gas storage injections over the summer will determine whether Europe enters winter with a buffer or a deficit. If Hormuz flows remain constrained, the adverse scenario the Commission sketched, growth near 0.5%, becomes the baseline.