The crises in Ukraine and the Middle East are eroding business confidence in Germany, a key indicator showed on Friday, amid signs that global turmoil could derail European recovery.
The Ifo economic institute's closely watched business climate index fell sharply to 108.0 points in July from 109.7 points in June -- the third drop in a row, to the lowest level since October 2013.
Analysts polled by Dow Jones Newswires had expected a smaller dip, to 109.4 points.
"Current business was seen as less good than in June and the outlook for future business was again less optimistic," the head of the Munich-based institute, Hans-Werner Sinn, said in a statement.
"Geopolitical tensions are putting strain on the German economy."
Ifo calculates its headline index on the basis of companies' assessments of current business and the outlook for the next six months.
The sub-index measuring current business slipped to 112.9 points from 114.8 points last month.
At the same time, the outlook sub-index fell to 103.4 points, a low point last seen in August 2013.
Wholesalers and retailers were particularly bearish, while companies in the construction industry were slightly less optimistic than in June.
The data came a day after the eurozone economy showed signs of a rebound in July after several months of sluggish activity, while its second biggest economic power, France, lagged behind.
However the private Markit research group, publishing its set of leading indicators, the purchasing managers' index (PMI), warned that the crisis in Ukraine and Western tensions with Russia were worrying investors.
- 'The Putin effect' -
Analysts said that Friday's Ifo report was cause for concern in Europe's powerhouse economy.
"The business climate in July clouded even more than was expected from the marked escalation in Ukraine, Israel and Iraq," DZ Bank in Frankfurt said in a research note.
"The insecurities that arise from international hotspots are weighing on the business climate and creating more cautiousness on the part of German companies."
Berenberg economist Christian Schulz called it "the Putin effect".
He said: "The conflict stoked by Russia's President (Vladimir) Putin in eastern Ukraine has a strong effect on the German economy."
He commented: "The sharp decline in the Ifo index in July pours cold water on hopeful signs that the German economy might weather the latest intensification of the Ukraine crisis without damage."
Germany has close trade and energy ties with Russia and its business community has long lobbied against tough economic sanctions.
Since the downing of a passenger plane over eastern Ukraine last week, however, calls have mounted for the European Union to take a firmer line against Russia for its support of insurgents in the crisis region.
- 'Worrying sign' -
Senior European economist Jennifer McKeown at Capital Economics in London said the drop in the Ifo indicator was "another worrying sign that the recovery may have passed its peak".
But she pointed to a relatively positive report on German consumer confidence on Friday as a ray of hope.
"Together with signs of rising wage growth in recent pay negotiations, this could add to hopes of a long-awaited consumer revival," she said.
Market research company GfK's monthly survey of consumer sentiment came in at its highest level since December 2006, driven by rising income expectations.
"Despite an escalation in the situation in Israel and Ukraine, German consumers remain optimistic this summer," GfK said.
Commerzbank said that while German economic growth was expected to continue, the Ifo report indicated that the uncertainty outside the country, the world's number three exporter, would put a damper on its pace.
"Whilst all leading indicators are still pointing to a continuation of the economic recovery in Germany, the decline in the Ifo index, in particular, suggests that expectations for the second half of the year should not be too high," it said.
The German economy ministry last month forecast a slowdown in the second quarter after a robust start to the year.
According to the Bundesbank's latest report, German gross domestic product was projected to grow by 1.9 percent in 2014 and then by 2.0 percent next year.