As Europe's largest economies grapple with domestic crises, the continent teeters towards an economic downturn.

• The political and economic challenges in Germany and France are causing Europe to appear to be heading towards an economic downturn.
• Both Germany and France experienced declines in their business activity in September, as shown by the data released on Monday. In Germany, the HCOB flash composite purchasing manager's index (PMI) reached a seven-month low, while in France, the composite PMI hit an eight-month low.

The political and economic challenges in Germany and France are causing Europe to appear to be heading towards an economic downturn.

In September, the business activity in the manufacturing and services sectors of Europe's largest and second-largest economies decreased significantly more than anticipated, according to data released on Monday.

The HCOB flash composite purchasing manager's index (PMI) in Germany dropped from 48.4 in August to 47.2 in September, which is a seven-month low and below the anticipated 48.2.

In September, the composite PMI in France fell to an eight-month low of 47.4, down from 53.1 in August and below the expected 50.6. A reading above 50 indicates expansion, while a figure below that suggests contraction.

In September, for the first time in seven months, the single currency area's business activity decreased, according to S&P Global, which compiled the data, falling from 51 to 48.9.

The latest PMI data reveal that Europe's traditional growth drivers, including Germany and France, are experiencing a sharp slowdown due to political upheaval and economic uncertainty.

According to Andrew Kenningham, chief Europe economist at Capital Economics, the sharp decline in the euro-zone Composite PMI indicates that the economy is slowing down significantly, with Germany in recession and France's Olympics boost being merely a temporary increase.

"France's new minority government plans to tighten fiscal policy significantly, which may lead to poor growth prospects, according to Kenningham. Meanwhile, surveys suggest that Germany is falling deeper into recession."

'Sick man' of Europe

Germany's economic downturn is not new, as the country's export-oriented economy has been flirting with recession for over a year now. Despite the latest PMI data, economists had predicted that Germany would grow only 0.3% in 2024, according to the Bundesbank. The European Commission's spring forecast was even more pessimistic, predicting just 0.1% growth this year.

According to Cyrus de la Rubia, chief economist at Hamburg Commercial Bank (HCOB), the latest PMI data suggests that a technical recession is likely to occur. He predicts that German GDP will decrease by 0.2% in the current quarter compared to the previous one.

Although GDP shrank by 0.1% in the second quarter, there is still hope that the fourth quarter will improve due to higher wages and lower inflation, which will increase real income and consumption, thereby supporting domestic demand.

Germany, once Europe's symbol of growth, is now being referred to as the "sick man" of Europe by economists.

"J.P. Morgan euro area economist Greg Fuzesi stated in a note on Friday that the German economy is still facing challenges in gaining momentum, which has led to concerns that the obstacles are structural rather than cyclical."

"The challenges are numerous, including Chinese growth and competition, higher energy prices, the green transition, changes in the car industry, an aging population, and a lack of investment in public infrastructure, which has negatively impacted confidence in the three-way coalition government's ability to address these issues."

French political woes

A new government has been established in France after months of political instability following an inconclusive snap election earlier this year, with Michel Barnier as the new Prime Minister.

The former Brexit negotiator and Conservative veteran has inherited a poisoned chalice, with the country facing acute fiscal challenges that require immediate attention.

Barnier must quickly create a 2025 budget draft for a vote in France's National Assembly in early October.

The government must submit a deficit reduction plan to the European Commission within weeks to avoid disciplinary proceedings, as its budget deficit continues to break EU rules. France has requested an extension of its deadline to submit debt reduction proposals.

The National Rally opposition, led by Jordan Bardella and Marine Le Pen, poses an ongoing threat to Barnier's government, and both the far-right and far-left could challenge the government via the New Popular Front (NFP or FP) alliance. Both blocs feel sidelined after the two-round election in June and July saw both perform well in respective rounds of the vote.

According to David Roche, president of Quantum Strategy, the Barnier-led government is unlikely to last beyond a year, which means much-needed economic and budgetary reforms will be put on hold.

The worsening of France's fiscal deficit and debts will result from France's defiance of the EU on the Excessive Deficit Procedure, according to Roche.

"The RN & FP will wait until the one year anniversary of the legislative elections, which is the earliest date new legislative elections can be held legally, before bringing down the Barnier hodge podge."

Roche advised staying short French government bonds, even if it requires patience.

In Germany, the Alternative for Germany party has gained popularity in recent state elections, as immigration, integration, and economic downturn have become major concerns among the public.

In the recent regional election in Brandenburg, Chancellor Olaf Scholz's center-left Social Democratic Party (SPD) barely managed to maintain its hold on power, with the AfD just barely kept at bay.

The defeat of the AfD in Germany could have significant consequences for the country's leadership, as the far-right party has gained popularity among certain segments of the electorate. The party won its first state election in Thuringia earlier this month and came a very close second in Saxony in a separate vote.

Eurasia Group founder and president Ian Bremmer stated earlier this month that the European Union's two largest economies are experiencing an implosion of their center.

The far left and far right performed well in the snap parliamentary election in France, but are now being excluded from the unstable minority government led by Michel Barnier. This has made their constituents more angry, and their leaders are not taking responsibility for governing their way out of the troubles. The arrangement keeps Macron in power for now, but only strengthens the extremes for upcoming elections.

The political developments in Germany are similar to those in other countries, with the AdD gaining political wins and their popularity predicted to continue to grow due to their strong anti-migrant sentiment, economic populism, and opposition to support for Ukraine, according to Bremmer.

"The European Union remains a strong political buffer with largely continuous leadership, which has halted growing efforts at exit. However, domestic policies are moving against the establishment and are part of a broader fragmented globalization trend, according to Bremmer. Much needs to be watched here."