Germany: Putting the Recovery to the Test

Elga Bartsch | London

In 2007, the much-applauded economic recovery in Germany and, more importantly, financial markets’ conviction in the revival story, will be put to the test, I think. This is because a number of negative factors will likely weigh on GDP growth in the coming months. The key question is by how much. My main-case scenario is that after several years of heavy restructuring, the economy should now be in better position to withstand negative headwinds without falling back into its old ways of dipping in and out of stagnation. On our forecast, real GDP growth will nonetheless slow from an estimated 2.5% in 2006 to its trend rate of 1.5% in 2007. This is two-tenths above consensus estimates in each of the years.

Don’t be fooled by the decline of the annual average growth rate though. The decline is almost entirely due to a negative real GDP growth rate in the first quarter of 2007. This forecast of an outright contraction in economic activity in early 2007 reflects a three-point VAT hike becoming effective on January 1st and a considerable fiscal consolidation package of around 0.75% of GDP of which it is a key part. But the German economy should be recovering from this shock as early as the second quarter. Due to the substantial hike in the VAT, consumer spending will feel the brunt of the fiscal tightening in 2007. As a result, consumer spending growth will likely halve from the 1.1%, it is likely to register in 2006. A considerable part of that weakness in consumer spending will simply be a payback after purchases of big ticket items that have been brought forward to late 2006 to avoid the higher VAT. A similar but less pronounced pattern is likely to be observed in residential construction investment. Notwithstanding such a temporary setback, the German construction industry is emerging from a multiyear recession, in my view.

Slowdown likely in machinery/equipment spending growth. Meanwhile, corporate spending on machinery and equipment, which has been a major driver of the recovery in the past few quarters, will likely to show moderation in growth rates in 2007 as profit growth slows, interest rates rise and wage bills increase. In late 2007, the prospects of tightening the depreciation rules under the planned corporate reform could provide a temporary boost to corporate investment spending. Given that pricing power is still limited in many sectors it is also likely that companies will have to absorb a part of the VAT increase in their profit margins. The downward pressure on profit margins will only be partially offset by a reduction in non-wage labour costs due to a cut in unemployment insurance contributions. A 2.3% reduction in the contribution rate to the statutory unemployment insurance will further boost cost-competitiveness of German companies, I believe. This along with the past wage moderation and still rapid labour productivity growth would act as boon against any further marked appreciation of the euro.

Internal tensions in the euro area could rise in 2007. The further improvement of the cost-competitiveness of German companies vis-à-vis their euro area peers will likely cause economic and political tensions within the euro area to rise next year. Germany’s unit labour cost dynamics have already been falling short of the euro area average by nearly 20 percentage points over the last 10 years, and the marked reduction in non-wage labour costs next year is likely to deepen the divide even further. As a result, export market shares should develop further in Germany’s favour. Some of the neighbouring countries, where domestic demand dynamics seem to have come off the boil as local house price momentum cools, might be looking at the combination of a cut in non-wage labour costs and a rise in the VAT as a new version of beggar-my-neighbour policies within a fixed exchange rate system. While such concerns are understandable, in my view, they miss the key point: the gales of globalisation.

German companies are not restructuring to take away market share from their French, Italian or Spanish competitors. They are restructuring to survive in the face of low cost competition from Central and Eastern Europe and Southeast Asia. As a high-wage country with above-average exposure to export destinations outside the euro area and a traditional capital exporter, Germany was the first to feel — and to react to — the gales of globalisation and their impact on the relationship between capital and labour seen in many industrialised countries. Other euro area countries will need to follow sooner or later in the recalibration of the share of wages and profits in national income seen in Germany in the last few years. But a potential rise in intra-euro area imbalances may also fuel political tensions within the European Union as long as governments remain in denial on how rapidly the global economy has changed already.

There can be no mistaking the risk of several negative factors causing a bigger than expected dent in German GDP growth over next 6–12 months. These negative factors, potentially hurting the cyclical growth momentum by more than expected include a three-point VAT hike implemented in January as part of a considerable fiscal consolidation package, a more pronounced slowdown in export demand due to cooling trade growth and a stronger euro, the lagged impact of past increases in interest rates and bond yields, the proclaimed end of wage moderation propagated by trade unions, and the introduction of minimum wages muted by the government reducing incentives for companies to hire and invest in Germany. On the positive side, the recent rebound in a number of sentiment indicators — such as hiring intentions for instance — suggest that the underlying momentum of the economy might be stronger than most forecasters (ourselves included) currently acknowledge.

In my view, the likely pullback in German GDP growth in early 2007 provides an opportunity to value-oriented investors to revisit the great restructuring stories in corporate Germany. A combination of slower top-line growth, rising margin pressure and a stronger currency will reinforce the need for strict cost-control and capital discipline. So make sure you have a list of best stock ideas handy when business sentiment starts to rebound. Historically, it was when the Ifo business climate started to rebound that the more cyclical German stock market outperformed its European peers.