Tuesday, January 25, 2011

Don't underestimate the German consumer

One of my major topics has been the extremely favourable short as well as long term outlook for the German economy (see for example the publication German Wirtschaftswunder 2.0 from May last year as well as the blog post German Wirtschaftswunder revisited from Nov 3). Germany is at the start of a multi-year virtuous circle with real growth around 3% on average due to structural reasons (high competitiveness of the German economy, relatively healthy fiscal situation, end of the decade-long high real rates period) as well as cyclical reasons (extremely accommodative monetary policy environment which via higher inflation and an improvement in credit availability becomes even more accommodative). While this thesis was initially an extremely out-of-consensus view, in the meantime expectations have shifted somewhat, especially with respect to the German industry amid the export-led recovery. However, compared to my base case expectations remain muted, especially with respect to the outlook for domestic consumption (as well as domestic investment). This should not come as a surprise given the decade long disappointing performance of German consumption (see chart below) where the real level of retail sales has not grown at all. Nevertheless, I am convinced that domestic German consumption growth will be strong in the years ahead.

German real retail sales (ex autos/gas, 2005=100)
Source: Bloomberg

Over the past decade, the German consumer has disappointed again and again as consumption remained weak and the savings ratio high. However, looking ahead the outlook is very bright. Essentially, consumption growth depends on the change of the sum of wages (and social transfers) being paid to households as well as the change to the savings ratio. Over the past decade, both have acted to depress consumption. Additionally, a host of structural reforms have acted to increase perceived uncertainty, resulting in higher precautionary savings. The combination of a cut in social security, an increase in the pension age, a watering down in job protection on the one side, coupled with a corporate sector re-establishing its competitiveness lead to a significant rise in unemployment early in the decade and a drastic reduction in perceived economic safety of a vast part of the population. In turn, not only remained real incomes more or less unchanged, but the reduction in the perceived personal security - amplified by the high real rate environment - propelled the savings ratio higher, a truly rational response by private households.
Now, however, the situation is turning around dramatically. The low level of unemployment/historic record level of employment is fuelling wage pressures and we should see marked rises in wage gains over the next years. Furthermore, at the same time it is also helping to restore economic security and coupled with lower real yields will see a large and prolonged drop in the savings ratio. Furthermore, the success of the German cash-for-clunkers scheme in 2009 has not only shown that German consumers react to incentives but also that the stock of durable goods (in this case cars) is relatively outdated. This should not come as a surprise given the low propensity to consume during the past decade, however, it suggests that there is a great level of pent-up demand for durable consumer goods in Germany.
Finally, amid the sustained drop in German unemployment the voices about an increasing lack of well-educated personnel are growing ever louder. Besides fuelling wage-gains, it is also very likely that it will fuel immigration of well-educated people. For one, these might be Germans who emigrated during the past decade given the poor economic circumstances prevailing in their home country but now find themselves in an underperforming economy such as Spain or Ireland. Additionally, it is also likely that Germany will start to attract a rising number of young and well-educated people moving from the peripheral Eurozone countries amid a lack of jobs. This article in the Swiss newspaper NZZ (in German) looks at some Italian people having moved to Berlin recently given the combination of better job availability and lower costs of living in the German capital. The result of increased immigration of well educated people will not only be to help consumption growth but also to improve trend growth.
From a longer-term perspective, German equities continue to appear attractive, though a shift from the more export-dependent companies/sectors towards the more domestic oriented companies/sectors makes sense. Additionally, the construction sector might as well show some signs of life following the 15-year long slump also fuelled by the increased willingness to spend as well as low real yields.

German construction orders (real value based index, 2005=100)
Source: DeStatis

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