A double dose of bad economic news Thursday -- a contraction in Ireland and a seven-month low in business activity in the euro zone -- caught investors by surprise and reinforced the notion that Europe is stagnating.

The purchasing-managers index for the euro zone slid in September, suggesting the 16-nation currency bloc is following the U.S. into a period of tepid growth too weak to dent unemployment.

Separately, Ireland said that its economy shrank by nearly 5% on an annualized basis in the second quarter. The contraction, following a brief expansion in the first quarter, startled investors already worried about the country's banks. Irish government bonds plunged Thursday, pushing the yield on 10-year bonds to 6.5%, a 0.20 percentage-point increase on the day and a record 4.2 percentage points above German yields.

In the euro zone, the manufacturing purchasing-managers index fell 1.5 points to 53.6 in September. Services, which make up the bulk of employment and output in the bloc, slid even further, to 53.6 from 55.9 a month ago. Index readings above 50 indicate an increase in business activity.

The European business-activity figures, along with recent data, are consistent with an annualized growth rate of around 1% to 1.5% in the euro zone this quarter, economists say. That is below the roughly 2% rate needed on a sustained basis to bring down unemployment, now at 10% in the euro zone.

The euro-zone's gross domestic product grew at an annualized pace of 3.9% in the second quarter, a four-year high and more than double the U.S.'s pace.

'Growth could peter out quite sharply by the end of the year,' says Ben May, economist at the consultancy Capital Economics.

The euro zone's slowing recovery likely reflects the effect of both a deceleration in global trade, due to a weakening expansion in the U.S. and Asia, as well as reluctance by European consumers to spend in the face of government-imposed austerity.

China, in particular, has served as an important source of demand in recent months for European exports but efforts by Beijing to temper lending in the country could be cooling trade with the euro zone.

Only a few weeks ago it appeared that Germany, buoyed by strong demand from China, Brazil and elsewhere, could withstand slower growth in key trading partners including the U.S. and Japan, and propel the euro-zone economy as a whole.

German GDP grew at a 9% annualized rate in the second quarter thanks to rising exports. The services component of Germany's September PMI survey, which economists say is a good proxy for consumer demand, declined but continued to show expanding activity.

The German GDP rise 'was so welcome, people said now we will have rocket-boosting figures' for the rest of the year, says Stefan Kirschsieper, chief executive of tool maker Walter Kottmann GmbH, a family-owned business in Wuppertal, Germany, that makes chisels for electric hammers used primarily in the building industry.

The reality, he says, is 'we cannot yet see that this will be a real stable situation.' Business in Germany is stable, Mr. Kirschsieper says, but in countries such as Spain, where sales depend heavily on the construction sector, 'there is nothing.'

The hopes of Germany and Europe being able to go it alone -- which economists call decoupling -- have been dimmed by a series of sober economic reports. In addition to the PMI slide, industrial orders throughout the euro zone sank 2.4% in July from June, suggesting a weak start to the third quarter.

Germany's economy, accounting for about one-third of the euro zone, is still expanding, but a nearly four-point drop in the country's September PMI to 54.8 suggests that slower growth in global trade is already having an impact.

A softening in German production wouldn't have been as much of a concern several years ago, when many of the euro-zone's smaller nations were notching rapid growth. However, as Europe tries to advance its recovery, Berlin is being counted on to offset continuing sluggishness among smaller members of the euro zone.

That dependency was highlighted Thursday by Ireland's dismal economic report. Though Ireland represents only 1.8% of the euro-zone economy, its problems are shared by other highly indebted countries along the zone's periphery, including Greece and Spain.

Ireland is struggling to recover from one of Europe's messiest real-estate busts, which has left its banks awash in souring loans to property developers that likely won't be paid.

Ireland's contraction signaled that the government may need to undertake even tougher austerity measures to reduce its massive budget deficit, the euro zone's biggest as a percentage of GDP. The deficit, which is now around 12% of GDP, is expected to soar due to the cost of bailing out troubled banks.

One big worry is that Ireland's economic woes will amplify its fiscal and banking problems. A weaker economy means less tax revenue, making it harder for the government to meet its goal of cutting the deficit to Europe's limit of 3% by 2014. As the economy weakens, Irish borrowers will find it harder to repay their loans, saddling the country's banks with more bad loans. That, in turn, could force the Irish government to provide more financial assistance, eroding its own creditworthiness.

In recent weeks, some investors have begun to fear a Greece-style bailout for Ireland, though many observers say it is unlikely for now, in large part because Ireland has financed its budget until the middle of next year.

The velocity of Ireland's contraction will likely rekindle a debate over whether Europe's pursuit of austerity in the face of a fading recovery is doing more harm than good. Just months ago, Ireland was winning widespread praise for the quick and decisive steps it has taken to cut its deficit.

Despite the bleak outlook in Ireland and Greece, many economists say a double-dip recession is unlikely in the euro zone as a whole. The euro fell only slightly on Thursday's economic news, easing about 0.3% to $1.3348 Thursday n New York.

European Central Bank President Jean-Claude Trichet has dismissed any risks arising from Europe's differing economic fortunes, but some economists say the ECB is underestimating the threat posed by the periphery.

Brian Blackstone / Neil Shah