Eurozone private sector activity growth has slowed to its lowest level since May of last year, as conflict in Iran drives up inflation and threatens a fragile economic recovery. The preliminary reading of the S&P Global Composite Purchasing Managers' Index (PMI) for the region fell to 50.5 in March from 51.9 in February, though it remains above the 50-point threshold that separates expansion from contraction. Analysts had expected a slight decline to 51.

In Germany, the largest economy in the eurozone, the composite PMI dropped more than anticipated but stayed above 50. France fared worse, with its reading falling below the 50 mark for the third consecutive month. In both countries, services sectors showed weakness while manufacturing performed relatively better.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, stated that the preliminary PMI data are sounding a stagflation alarm, as Middle East hostilities fuel sharp price increases and dampen growth. He noted that business costs are rising at the fastest pace in over three years, driven by surging energy prices and supply chain disruptions due to the conflict.

The ongoing Middle East conflict is endangering already modest economic growth, with markets increasing bets that higher interest rates will be needed to curb resurgent inflation. Although hopes remain for a swift resolution, investor sentiment has deteriorated significantly amid signs of lasting damage to oil and gas infrastructure.

The European Central Bank is currently in a wait-and-see mode, wary of potential rapid shifts in strategy by U.S. President Trump. However, officials have not ruled out the possibility of raising borrowing costs as early as the next policy meeting in April, according to sources familiar with the matter.

Boris Vujčić, a member of the ECB's Governing Council, emphasized that while stagflation is not yet evident, risks are moving in that direction, urging colleagues to maintain high flexibility and vigilance.

David Powell, Senior Eurozone Economist, pointed out that the PMI survey indicates a noticeable slowdown in the monetary union's economy as the Middle East conflict weighs on activity. He warned that conditions could worsen in the coming months as temporary factors supporting manufacturing in March fade. The ECB may have underestimated the negative impact on output and could eventually need to moderate its hawkish rhetoric.

Following the PMI release, Germany’s 10-year government bond yield held steady near 3%, while the euro extended losses, falling 0.2% to $1.1593. Money markets are pricing in increased monetary tightening, anticipating around 70 basis points of rate hikes by year-end.

S&P Global noted that the PMI showed the largest drop in future output expectations since the Russia-Ukraine conflict four years ago, with input prices rising at the fastest rate since February 2023. Williamson added that the outlook depends on the duration of the war and any lasting effects on energy and supply chains, but the preliminary PMI data highlight that the ECB is no longer in a "comfort zone" regarding growth and inflation. Faced with clear and rising stagflation risks in the coming months, policymakers will need to tread a cautious path.

PMI data are closely watched by markets due to their early release each month, offering timely insights into economic trends and turning points. As business surveys measure the breadth rather than depth of output changes, they do not always align directly with quarterly GDP figures.

In the UK, the composite PMI fell more than expected but remained above 50. U.S. PMI figures, scheduled for release later in the day, are expected to hold steady at 51.9.