Auf Wiedersehn to the crisis

Germany, the largest economy in Europe, has seen optimism surrounding its recovery further fuelled by the recent release of some impressive figures. So, has the time come to say “Auf Wiedersehn” to the economic crisis, asks Rodrigo Amaral, or is it too early to say?

Optimism about the global economy has been given an extra boost in August as even that most economically moribund of regions, the eurozone, has shown signs of coming back to life.

The example has come from the top. By posting a 0.3% rate of GDP growth in the second quarter, Germany, the largest economy in the eurozone, has shaken off its own recession much sooner than most analysts had forecast. Has the time come to say “Auf Wiedersehn” to the economic crisis?

Teutonic prowess has guaranteed that such a suggestion does not sound as far-fetched as it did a couple of months ago.
The German economy confounded the experts, particularly in the Anglo-Saxon world where the Continental economies are seen as lost causes for the science of economics. Their case has not been supported, either, by that notorious economic laggard, France, which has also seen fit to emerge from recession earlier than expected.

For investors hungry for positive indications in the developed world, which has appeared to lag hopelessly behind Asia and other emerging econ­omies on the road to recovery, the news from both sides of the Rhine, but particularly from Germany, has been equivalent to an invigorating meal of Eisbein, Sauerkraut and potato dumplings.

It may still be too early, however, to uncork that bottle of Cristal and get the party started. Some observers of the German economy, although as a rule impressed by the numbers disclosed in August, would argue that the wisest thing to do is to keep even the Liebfraumilch safe in the cellar.

Although Germany may have left the worst of the crisis behind and looks to be out of the intensive care unit, experts say that the country still has a long way to go before it is allowed to leave the hospital. “We currently have a strong recovery of leading indicators, but only tentative signs of an actual economic recovery,” says Jens-Oliver Niklasch, a senior economist at Landesbank Baden-Württemberg, LBBW, a Stuttgart-based bank. “It seems a recovery is going on, but we still don’t know where it will lead.”

The figures showing the German economy had started to grow again were greeted with enthusiasm by the markets for two main reasons. The first is the sheer weight of the German economy, the fourth biggest in the world, which accounts for more than a quarter of the eurozone’s output. More to the point, the country’s large exposure to foreign markets can be seen as a barometer of the global recovery. Germany is the quintessential export economy, with activities related to sales to other countries amounting to about half its GDP. For the German economy to grow, a necessary condition is that other countries are growing too, so they can buy Germany’s products.

This fact becomes even more obvious when one considers the profile of German exports. The image of its manufacturing sector is polished by the likes of Audi, BMW, and Porsche with their classy drives. But the main strengths of German exports lie mostly on a more basic level. Its companies have a well-deserved reputation for providing reliable, accurate and robust capital goods – that is, those machines and equipment that are used to produce other things. A pick-up in German exports, therefore, could imply that companies in other countries are more confident about their businesses and have resumed investment in their production lines.

Therefore the mood of German companies is closely followed as a useful indicator to give a rough idea of the prospects for the world economy. A few days after the German government announced that GDP had grown in the second quarter, the Munich-based Ifo Institute released its eagerly awaited business climate index, and once more forecasters were taken by surprise.

In August, the level of confidence among business people reached 90.5, up from 87.4 in July, easily beating the most optimistic forecasts. Germans are seen as a cautious people, not given to bursts of euphoria. If their companies are looking ahead with optimism, it is no wonder that the number of bulls in the financial markets has been swelling again.

Other indicators have given fodder to the positive view on the German economy, such as the increase in the country’s private sector output for the first time in 11 months in August. The service sector has also expanded at the fastest pace in 16 months. Encouraged by the stream of favourable data, the most enthusiastic have even talked of a “V”-shaped recovery of the German economy, bringing the rest of the European Union on its tail. For several reasons, as detailed further below, that may sound premature. But a case could certainly be made that it is high time for investors to set their sights on the German market again.

“I wouldn’t be too cautious [on the prospects for the German economy],” says Oliver Maslowski, a fund manager at Julius Baer Asset Management in Zurich. “I’m actually quite optimistic about Germany. It seems that we could be at the beginning of an upswing cycle.” Germany’s main stockmarket index, Frankurt Stock Exchange’s Dax, has been gaining ground in recent weeks, following the global trend for the sector. After falling as low as 3,588 points in March, the Dax closed August at 5,464, a 52% increase. Even then, analysts believe there still is margin for further growth.

“We may see the Dax reaching 6,000 points, which was the level before Lehman Brothers went bust,” says Maslowski. “At the moment, markets are still pricing out the risks of a worldwide depression. The Dax is trading 15% below its five year price/book average. That makes German stocks look attractive.”

The recent performance of German companies has also fuelled optimism that they could do well in the months to come. “Earnings have the potential to recover quite strongly, not to the record levels of 2007, but to healthy levels nonetheless,” claims Tim Albrecht, a senior fund manager for German Equities at DWS Investments. “If you believe in a reasonable recovery of the economy, companies’ valuations look attractive today.” Maslowski has a similar view when it comes to earnings. “In the second quarter we saw more surprises on the upside than on the down side, and no more downwards revisions are likely for the coming quarters,” he says.

Albrecht points out that German equity markets could be part of a diversification strategy by cautious investors who are getting tired of government debt vehicles and their shrinking returns. This is the case of utilities companies, he says, despite the fact that they are unlikely to post furious rates of growth in the near future. “Some German utilities companies have low risk profiles and could provide yields of about 5%, looking like good alternatives to bonds,” he argues.

Another sector Albrecht views with optimism is industrials. “Companies have been telling us that clients are back and feel more confident,” he says. “There is potential for industrial companies with healthy balance sheets.” For those who are not afraid of an extra level of risk, there is the option of investing in Germany’s hundreds of listed small- and middle-sized companies, some of which are world references in areas like machinery, car parts and engineering. “There are ­family companies where the controlling shareholders work with long-term strategic plans and which have resilient margins,” says Albrecht. “These are the sorts of companies we want to own over the cycle.”

The German stockmarket includes many cyclical companies, and as a consequence has the potential to rebound strongly once the economy gets going again. The problem with the present crisis is that almost no one feels confident enough to augur sustained economic recovery in Germany, Europe or almost anywhere else.

If firms and investors sound more upbeat on the future of the German economy, experts and officials have been trying to play the enthusiasm down a little, pointing out that it is still far too early to say the country is out of the rocks. Axel Weber, the head of the Deutsche Bundesbank, Germany’s revered central bank, has indicated that the good news does not amount to much more than the removal of the “downside risk” from his forecast that the economy will shrink by 6% in 2009.

Even though the Deutsche Bundesbank has said in its latest monthly report that the economy has reached bottom and recovery looks imminent, many uncertainties remain that could cause disappointments to the most sanguine of investors. The finance ministry has also warned that the situation is still fragile and that the recent good news should not by any means be interpreted as a sure sign that the crisis has been overcome. Even chancellor Angela Merkel, who faces a general election in the end of the month and could have felt tempted to play up the numbers, warned that the German economy has bottomed out but remains well short of the levels of one year ago.

To a great extent, Germany’s weak points coincide with the reasons why it would be well positioned to benefit from the eventual global recovery. The thermometer of the global economy is actually more exposed to some parts of the world than to others and depends on the performance of their main clients to heat up too. Many German export products are exactly what the doctor ordered for companies willing to boost their production lines after the storm. But if countries such as America, Britain and Spain, which are big buyers of German exports, insist on their current sluggish ways, Germany is bound to suffer too.

Economists have noted that China and other Asian markets have been steadily replacing the West as the main drivers of the world economy. But this fact offers little solace for many German companies.

“At the moment the recovery is concentrated in some emerging markets, mostly in Asia, but German exports don’t have a huge presence there,” says Christian Dreger, an economist at DIW Berlin, a research centre in the German capital. “The Middle East, Eastern Europe and Russia are more important emerging markets for German companies than Asia, as exports for those countries grew by double-digit rates in recent years. But they are closed for exports in the current year and prob­ably in 2010 too, which will delay the German recovery.”

Some of the countries that have pushed forward the global economy this year, like China, South Korea and even Japan, are also export-driven economies. China, which by some accounts has overtaken Germany as the world’s biggest exporting power, can even boast a trade surplus with the Germans. Second-quarter statistics revealed a welcome surge of sales to other countries, but exports remain well below potential. “As far as production and exports are concerned, we are still 25% below the time when Lehman Brothers imploded,” Niklasch notes.

The reliance on exports to drive the economy explains why the country’s GDP fell by 6.9% in the first quarter, on a yearly basis. As Germany’s major export markets are still struggling, some economists believe the recent economic growth may have been a blip fuelled by extraordinary factors that cannot sustain the economy for long.

“The rebound in the second quarter looks to some extent technical, resulting from the money infused by government incentives and from lower interest rates,” argues Natascha Gewaltig, the director of European ­Economics at Action Economics in London. “The different timing of Easter compared to last year might have played a role too.”

The main factors, according to Gewaltig and others, were measures taken in recent months by the government to revive the economy. An estimated €85 billion (£75 billion) has been injected by the state to help keep consumption up and to convince companies not to promote massive lay-offs.

As a result, Germany’s labour ­market and consumption remain little affected by the downturn. One of the programmes implemented by the Merkel government was the original “cash-for-clunkers” initiative, which would be subsequently copied by other countries, including America and Britain. It has helped to avoid a major disaster for car makers and their providers, which are essential for the German economy.

The problem is that there is a limit to what official stimuli can achieve, and anyway, the German government has already taken public deficit to more than 6% of GDP, doubling the 3% ratio allowed by the rules of the euro. For instance, a report by Roland Berger, a consultancy, has caused alarm by forecasting that incentives for Germans to swap their old cars are only delaying a major transformation in the industry that will mean the closing off of plants and the loss of thousands of jobs. Other analysts have noted that the low volume of credits conceded to companies in recent months does not bode well for an economy in need of investments to gather steam.

But the government has indicated that it is prepared to make further efforts to restore the flow of money to companies, including a programme to guarantee credit insurance contracts, which are vital for exporters. A positive is that the German banking sector does not look as bad as those in countries such as America or Britain. In a recent report, the Deutsche Bundesbank has even claimed that Germany has not suffered a credit crunch at all.

Lending to companies may have slowed down, but that would be a natural consequence of the reduced activity that is typical of a recession, says Dreger.

More worryingly perhaps, even though few people have lost their jobs and prices have come down, there is no sign that Germans are eager to spend their way out of trouble. The second- quarter numbers have in fact shown that imports suffered a sharp drop between April and June. “Lower demand for imports is usually a sign of weakness of the economy,” says Dreger.

Germans’ unwillingness to separate themselves from their money sounds like a particular concern for proponents of the view that it is necessary to correct the imbalances of the global economy to stimulate widespread growth. Germany is one of the countries that have been urged to become less dependent on exports and to stop financing the lax consumption habits of free-spending Americans and Britons with their savings.

A change of course like this looks a daunting proposition in a country where saving money is a ­valued cultural trait. Policies usually advised to achieve that end, such as cutting taxes to try to convince people to put their hands in their pockets, may have the opposite effect. “Here, lower taxes increase the risks of higher saving rates, rather than boost spending,” Dreger says. “Household savings rates have already increased due to the decline in oil prices and inflation.”

Dreger also points out that domestic consumption could hardly make up for the loss of exports because the capital goods that German companies mostly sell abroad are not in demand by the general public. Anyway, he says, although it is true that private consumption has been moving downwards since 2001, Germany’s ratio to GDP stands at the European average, which does not single out the consumers of Berlin, Munich or Frankfurt as especially stingy. “We have no particular weakness in private consumption here,” Dreger says. “In 2001, Germany’s consumption levels were well above the European average.”

This situation could change, though. In recent analyses of the German economy a recurrent concern is the risk of a sharp rise in unemployment that would make the population even lesswilling to splash out money. So far, companies have envisaged keeping their workforce, in some cases by agreeing reduced shifts and temporarily lower pay, in order to avoid a scarcity of skilled labour that affected them in the aftermath of previous recessions. But other factors could play a role in the evolution of the employment rate.

Flexible work arrangements have been helped by government ­subsidies, which will not last forever. And many people may have a nasty ­surprise after the general election at the end of September.

“We expect a sharp rise in unemployment because the level of demand is too weak to keep the current levels of employment,” Niklash says. “But there are rumours that companies are delaying lay-offs until the election is over.”

If that really takes place, even a sustained economic recovery might not be enough to bring employment back to pre-crisis levels. Niklash points out that German companies have improved productivity by annual rates of 1-2% for several years already. Since the early 2000s, productivity gains have reached an accumulated 15-20%, he notes. “Many companies can resume their pre-crisis levels of activity with much fewer people than they employ today.” Capital Economics foresees a “nasty turnaround” in unemployment that will all but guarantee that the German recovery will be at best quite modest in 2010 and 2011.

What few people expect is that the aftermath of the German election, scheduled for September 27, brings big surprises in the area of economic policy. Polls give Angela Merkel, from the conservative Christian Democratic Union (CDU) party, a firm lead over her main rival, Frank-Walter Steinmeier of the Social Democrat Party (SPD). Although the CDU has suffered serious setbacks in two regional elections at the end of August, the main doubt seems to be who will partner Merkel in the federal government.

At present the CDU and SPD are governing in an odd grand coalition forced on Merkel, after an inconclusive vote in 2005. Steinmeier himself is Merkel’s foreign minister and vice- chancellor. Free marketeers hope that this time she will be able to ally herself with the Free Democratic Party (FDP), a resurgent and very liberal party, allowing her to promote further reforms to liberalise the economy.

Only a major turnaround would bring the centre-left SPD back to the top. But even in such circumstances it is unlikely that Germany would turn its back on business, analysts say. They point out that the latest round of ­economic reforms implemented in the country, in the 1990s, was the work of Gerhard Schröder, an SPD man.