Under the bonnet as Europe’s largest economy slows

Germany still on course for growth as trade issues hit industrials

Photo by Jan Böttinger on Unsplash

In 2018, the German economy grew by less than the eurozone average for the first time since the financial crisis; and forecasts this year look even more bleak. Leading German research group the Ifo Institute recently slashed its full-year forecast for Europe’s largest economy to 0.6%

“The German growth engine is its industrial sector but it’s faltering at the moment,” says Ernst Matthias Hänsel, a fund selector at W&W Asset-Management in Ludwigsburg in the Hesse region, which is the heart of Germany’s automobile industry.

“Industrial companies and especially auto manufacturers, which are Germany’s largest exporters, are facing structural problems, which has impacted production and negatively affected earnings forecasts.”

Das auto

It is Germany’s huge automobile sector that faces the most acute challenges. Car production collapsed in December as manufacturers struggled to implement stricter European emission standards. Production has recovered a little this year but it remains well below previous years as the industry grapples with the double whammy of a cyclical downturn and a structural upheaval led by the growth in electric vehicles.

Industry giants such as Volkswagen have been forced to make significant investment in new technologies. “It’s a costly gamble,” says Thomas Romig, head of multi-asset at Assenagon Asset Management in Frankfurt.

“Volkswagen is planning to invest billions of euros in the development of electric cars. But as a full transition to electric transport is a long way off, it’s unclear whether this will be a profitable table investment.”

The hefty cost of transition to electric vehicles is not the only structural issue automakers face. “Secular developments in the automobile sector, such as the rise of car sharing and increasing urbanisation, will also put pressure on car sales in the coming decade,” says Hänsel.

“Car companies need to reinvent themselves from manufacturers into providers of mobility services, and in Germany carmakers are only at the start of this change.”

To add to car manufacturers’ woes, an economic squeeze has led to a slump in exports to key markets, which also threatens much of Germany’s export-dependent industrial sector.

Exports account for more than 45% of German GDP, according to the World Bank.

“The US-China trade war, the threat of US-imposed import tariffs on German cars and the uncertainty surrounding Brexit all weigh on foreign trade. Germany is more dependent on exports than most other European countries,” says Romig.

Weakness in key emerging market countries has also a­ffected growth. The volume of German exports to Turkey, for example, has fallen by a third since 2017.

Some carmakers have already reduced workers’ schedules because of the lack of work. Similar measures were introduced in the aftermath of the global financial crisis.

As a consequence of the weak export climate, the Ifo Business Climate Index, a bellwether indicator of economic growth, was down from from 99.3 points in January to 98.5 in February: the lowest level since December 2014.

The reason the index hasn’t fallen further is because German consumer spending has remained strong.

In January, retail sales increased by 2.6% on a year-on-year basis. This contrasts strongly with the 3.3% drop in industrial production during the same month.

Investors have also taken notice of the changing macroeconomic environment.

The bluechip Dax Index has significantly underperformed the Euro Stoxx 50 over the past 18 months. German stocks look cheap as a result, but for a good reason.

“German stocks have potential for a recovery, but a rebound may still be some way o­f,” according to Romig. “Global economic uncertainty remains high and discussions between China and the US about a trade deal are ongoing. US import tari­ffs also remain a possible threat.”

Hänsel has also been shunning German equities. “We haven’t had an overweight to German equities for more than a year now. And most of the active managers we have selected don’t either,” he says.

It’s not only automakers and industrials that face bleak prospects. The German government has been proactive in encouraging the shift to green energy and German utilities have invested heavily in renewables. But this transition has pushed up energy prices, making them among the highest in Europe, hampering many energy-intensive companies’ competitiveness in the process.

German banking stocks are particularly cheap at the present time, says Romig, although like many investors he is not tempted to invest.

“Many commercial banks tend to focus on the domestic market, which is dominated by state-owned lenders. If your competition doesn’t need to make a profit, it’s difficult to compete,” he says.

Such sectoral weakness is one of the factors behind the mooted merger between Germany’s largest commercial lenders

Time and again, Germany has shown that it is able to reinvent itself.

In the early 2000s, foreign media labelled the country the ‘sick man of Europe’ as the huge cost of reunification squeezed growth and pushed up unemployment. Only a decade later, it once again emerged as Europe’s economic powerhouse.

As structural factors have led the economic slowdown, the million-euro question is when will Germany be able to bounce back?

“Macroeconomic uncertainty and external risks are now higher than they have been in a very long time. But on the other hand, the fundamentals of the domestic economy remain strong,” says Carsten Brzeski, chief economist at ING Germany.

“Investments in the German economy, especially in digitalisation, are still rising on the back of low interest rates, and you see companies repatriating production to Germany from emerging market countries. The federal government also has low debt and a budget surplus, so there’s room for more fiscal stimulus.

According to Brzeski, risk of recession remains “very low” at present and despite the structural shortcomings in the economy, Germany is still on course for growth over the next couple of years.

Demographic challenges

In the medium term, however, Germany’s economic potential remains hamstrung by its shrinking workforce.

The country has one of the lowest birth rates in the world, with the population expected to shrink from 80 million to about 70‑million during the next few decades.

As a result, Brzeski says migration has a crucial role to play in determining the future of Germany.

In 2015, German chancellor Angela Merkel allowed hundreds of thousands of refugees to apply for asylum in the country in response to the migrant crisis.

“Much depends on the integration of refugees into the labour market,” Brzeski says.

“If refugees become tax-paying employees, this demographic change will be reflected less in the labour market. That would increase the longer-term growth potential of the economy from 1% to 1.5%.”

The early signs are positive. Refugee unemployment dropped from 50% to 40% last year, and one in four refugees is now officially registered as having a job, according to figures from Germany’s Institute for Employment Research.

Migration from other EU countries and elsewhere has also risen sharply in recent years. In 2017, EU net migration reached almost 200,000 people. On top of that, almost 22,000 non-Europeans migrated to Germany under an EU scheme to attract highly qualified workers.

“This rise in migration has partly alleviated the problem of a tight labour market,” Brzeski adds.

Hänsel remains positive about the medium-term prospects for the domestic economy but recognises the country remains vulnerable to external forces beyond its control.

“The German mittelstand – small and medium- sized enterprises – remains strong and many German SMEs are world leaders in their fields,” he says.

But, like much of the German economy, many small and medium businesses are heavily dependent on exports.

As the US and China inch towards a resolution to their trade dispute, many analysts expect US president Donald Trump to turn his attention towards EU and German trade.

Hänsel warns: “If Trump wins another term in 2020 and continues his erratic economic policies, it could really impact global growth and negatively.”

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