German Wirtschaftswunder revisited

I have been arguing for a long time that the multi-year outlook for the German economy is extremely positive (see for example There is more to celebrate for Germany from Nov last year or German Wirtschaftswunder 2.0 from May this year). In the meantime, economic data out of Germany has surprised most economists and investors. While growth projections have been revised upwards, I remain convinced that the outlook for the German economy (and thus for German real and financial assets) is by far much more favorable.

There are various reasons why this is the case:
a) German corporates have become extremely competitive over the past decade. During the first years of EMU they had to largely regain competitiveness vs. the rest of the Eurozone as Germany locked in an uncompetitive exchange rate when the euro was formed and German corporates were heavily in financial deficit following the debt-financed M&A boom during the dot-com bubble. In turn, at the start of the last decade German corporates had to restructure (i.e. cut costs - especially via headcount reduction in Germany and offshoring/outsourcing) to regain cost competitiveness and reduce the financial deficit. Unfortunately, as Germany regained internal competitiveness during the last decade, the external value of the euro soared, especially vs. key competititors such as Japan. However, over the past 2 years, the euro has lost altitude - again especially vs. key competitors - and German corporates for the first time since the start of EMU are competitive on an intra-Eurozone and on an extra-Eurozone basis. Additionally, German corporates on aggregate have moved from a financial deficit into a financial surplus.

b) German households have been burdened over the past decade by the restructuring of the corporate sector and the numerous reforms by the state of amongst others the labour market, the unemployment benefits as well as the pension systems. In combination they had the effect of rising the financial risks carried by each individual (via lower job security and lower social security), temporarily increasing unemployment and reducing wage growth. All this put downward pressure on the sum of wages earned and upward pressure on the German savings ratio, in turn creating an environment of weak domestic demand. However, now the sum of wages earned is increasing (as unemployment dropped sharply and we are likely to enter an upcycle in wage growth) while no more significant structural reforms are on the agenda. In turn, the outlook for consumption growth has become favorable as well for the first time since the start of EMU.

c) The Germans state was forced to carry through numerous structural reforms as well as several rounds of fiscal tightening to reduce the structural fiscal deficit. However, at present the situation of German state finances is relatively healthy and in turn the need to carry through fiscal tightening measures is limited. The German government decided to engage on a 4-year tightening programme, but on average the tightening amounts to only approx. 0.25% of GDP per year. Furthermore, as the economy is doing better than anticipated, fiscal deficits are undershooting the projected levels by a significant margin.

d) At the start of EMU, Germany had a high price level which combined with weak economic developments resulted in below-average inflation and thus in above-average real yields, further restraining the economy. Now, however, the German economy is roaring ahead which should lead to inflation being more in-line with the Eurozonea average. Additionally, intra-Eurozone sovereign spreads are very high and as a result, Germany is enjoying the lowest real yields within the Eurozone. Finally, as the outlook for the German economy is favorable, credit conditions are easing. As a result, for the first time since the start of EMU, Germany enjoys a very accommodative monetary environment.

What is more, all of these factors re-inforce each other. While at the beginning of the last decade this lead to a vicious circle whereby weakness in the corporate sector, the household sector, a restrictive fiscal and monetary environment all reinforced each other, we are now just at the beginning of a virtuous circle.
The strength in the corporate sector is leading to more employment and with that wage and consumption growth. The outlook for the domestic economy is thereby improving, leading corporates to invest more and banks to provide more funds (as the perceived credit risk is lowered). The fiscal deficit is reduced which reduces the need for fiscal tightening/opens the door for fiscal easing. Domestic inflation picks up which - given that Germany outperforms the rest of EMU - leads to lower real yields, further promoting more investments and a lower savings ratio. Within the monetary union if a country starts to outperform in economic terms, its monetary environment becomes even more accommodative not less, further reinforcing the upswing.
Given the favorable starting point for Germany in terms of corporate competitiveness and low private sector indebtedness such a virtuous circle can last for years without leading to cost disadvantages and/or over-indebtedness.

We are just at the start of this virtuous circle where the drop in unemployment - due to the export led growth rebound - starts to fuel wage gains and coupled with low real yields promotes a reduction in the savings ratio. This will create an increasingly favorable environment for domestic demand and lead to the next wave in growth. I remain convinced that Germany will show above trend growth for the next 3-5 years. While there will be ups and downs in quarterly growth numbers, I continue to look for growth to average around 2.5-3%.

Blog Reactivation

I hope to become more active again with this blog from now on. Please apologize for the temporary blackout period but I have been busy with other ventures. In the meantime I also updated my website www.researchahead.com (English version) and www.researchahead.de (German version).

Any feedback appreciated.

All Good Things Come to an End

I remain sceptical with respect to the economic effects of QE2. Subdued growth is here to stay for a prolonged period in the US as households will deleverage further whereas the government sector has to rein in its deficits over the medium term. Additionally, I don’t expect inflationary pressures to grow meaningfully over the foreseeable future. There is ample spare capacity as can be seen for example by the high unemployment rate and with muted Growth this is unlikely to change soon. Furthermore, the money being created by the next round of QE will likely lead to another significant rise in banks’ excess reserves and in turn not hit the real economy. As a result, there will continue to be too many goods being chased by too little money. The main effect of QE will be to support asset prices/reduce yields. However, the example of Japan has shown that low yields per se do not help much in fuelling aggregate demand or inflation if it does not fuel credit creation (see chart below).

Japanese monetary aggregates and economic activity (avg yoy change 1995-2000)

Source: IMES

In turn, US nominal growth should remain at historically low levels, warranting also low nominal bond yields for an extended period of time. My fundamental fair-value range for 10y UST remains at 2.50-3.00%. I was looking for UST yields to trade around the lower end of this range into autumn and for a low point to be reached during November before yields would be rising to the high end of the range during the winter months. A key reason for this assessment is economic seasonality. During autumn the economy usually re-accelerates following the summer lull. However, as the economy operates significantly below potential, this seasonality should not be as pronounced as is usually the case. In turn, I expected seasonally adjusted data for September and October to come in on the weak side. So far this is indeed playing out and economic data suggests that the US has significantly lost momentum going into autumn. But as the chart below shows with the help of the US employment report data, this seasonal effect is reversing during the winter months with generally weaker economic activity. As a result, I expect that seasonally adjusted economic data will increasingly paint the picture of an improving growth environment for the next few months (especially for December/January).

Economic activity usually weakens during winter

Source: BLS, Research Ahead

Given that the US Federal Reserve is now likely to embark on another round of QE just before this seasonality effect kicks in, the combination an even looser monetary policy with apparently improving economic environment will likely propel nominal bond yields sharply higher, i.e. well above the upper end of my fair-value range. Additionally, the prospects for QE2 have been mirrored by a marked shift in positioning in the UST market. Long duration position as measured by non-commercial longs in the US bond futures market or as measured by the JP Morgan survey of US institutional investors have become rather consensus and are at the highs for the year. Furthermore, whereas the technical picture up to the 10y part of the curve still looks supportive of ongoing yield drops, the developments in the 30y sector are sending a clear warning signal.
The combination of a likely improvement in the macro-economic picture over the next few months, significant long positions as well as a worsening technical picture for ultra-long bonds suggests that the bull-market in UST is likely coming to an end soon. I think that the low pint in 30y UST yields is already behind us whereas for shorter-dated Treasuries this does not yet seem to be the case. I expect yields to continue falling over the next 2-3 weeks amid weakfish economic data and given the upcoming Fed meeting with the likely start of QE2. However, it seems prudent to lighten up on longs already at this point in time and I reducie the long-held UST longs by half, looking to close the remaining longs at slightly lower yield levels over the next 2-3 weeks.

Forming upward trend in 30y UST yield is sending a warning signal

Source: Bloomberg, Research Ahead

Whereas in the US, the technical market outlook is darkening from the ultra-long end, in the Eurozone, it is the short end which has been guiding yields higher. The chart below shows that the 2y Schatz yield marked a low in June and has since been forming on a rising trend. Furthermore, the downward trend which started in June last year has been broken to the upside by now. 10y Bund yields, however, formed their low at the beginning of September and so far have only just broken through the downward trend in place since March this year. I have been looking for such a significant underperformance of German Bunds compared to their US counterparts. The reason for these diverging trends between the US and the Eurozone should be seen in the diverging economic behaviour as well as the clearly different stance of the ECB compared to the US Fed. For one, the Eurozone economy is doing relatively fine amid the strong growth of especially Germany. Furthermore, the ECB does not see further monetary easing as being warranted and seems rather happy about the waning interest in its liquidity provision measures. As a consequence the excess liquidity in the Eurosystem has been dropping significantly, putting upside pressures on ultra-short end yields and leading 3m rates back above the ECB’s 1% repo rate for the first time since mid-2009.

Bearish developments in the Eurozone emanate from the short-end

Source: Bloomberg, Resesarch Ahead

In light of this less accommodative monetary environment and given the ongoing favourable outlook for the North-Eastern Eurozone economies, especially Germany, the fundamental environment in the Eurozone will be increasingly favouring higher yields . As a result, German Bund yields have likely seen their yield lows across the curve and – similar to the US – should rise substantially during the next few months. Amid the tighter monetary environment as I expected initially, I raise my fair-value range for 10y Bunds from 2.25-2.75% previously to 2.50-3.00% and expect a test of the upper end during early 2011. In turn, I would close the remaining long positiions and establish first strategic short duration positions with a view of 3-6 months. The bearish development should be led by the 5y sector of the curve with the 2-5y spread stable to higher and the 5-30y spread likely to move to flatter levels.

Importance of SGIP for North-Eastern economies is low

It is well-known that sovereign defaults in Spain, Greece, Ireland and Portugal would have devastating effects on the financial sectors of the rest of the Eurozone. However, I am convinced that while technically these countries might be insolvent they will not need to default given that the EU/IMF/ECB measures will keep them liquid. As I argued in the previous post (see Intra-Eurozone competitiveness: A solvable task) especially Spain, Portugal and Ireland have a high probability of being able to restore competitiveness and bringing their fiscal deficits back on a sustainable path over a period of 3-5 years whereas the outlook for Greece remains more challenging. The price to pay will be a longer-lasting deflationary recession and a significant increase in the sovereign debt-GDP ratio. However, especially for Spain and Ireland this should not be such a big problem as the starting debt-GDP ratio has been fairly low.
For the banking sector of the other Eurozone countries the fact that SGIP remain liquid and do not need to default while the ECB provides a floor to government bond prices means that the losses they incur are limited. Furthermore, the banks can slowly offload parts of their sovereign debt via the ECB's bond buying and as the EU/IMF refinance the maturing GGBs. Finally, the rising private sector defaults in SGIP will occur over a number of years and the sums involved appear manageable for the Eurozone financial sector.
What remains for the rest of the Eurozone are the economic effects from reduced demand by SGIP. I hear frequently that given Germany is such a big exporter and given SGIP are in a longer-lasting recession, Germany cant grow amid lack of export demand. However, it seems that no one looked at the data as this is just not true.
The table below shows the share of exports going into a particular region relative to total exports for various Eurozone countries. Due to data availability it covers only export of goods but not services (services account for about 20% of all exports). It highlights that the share of exports going to SGIP relative to overall exports is low for most Eurozone countries. In 2008 Germany exported only 6.6% of all exports to SGIP. This has come down further in 2009 to below 6% (EUR48bn vs. total exports of EUR808bn). According to Bundesbank data for services, the picture is the same. Germany exported 6.2% of all exports in services to SGIP in 2008 and 5.6% in 2009 (EUR 9.3bn vs. a total of EUR165.5bn). Except Portugal, due to the high export share going to Spain, only France and Italy have a share of more than 10%. As a side note, the UK – even though not being a Eurozone member - has a share of more than 12% of exports going into SGIP. Overall, demand weakness emanating from SGIP should not have a dramatic effect on the rest of the Eurozone.
Furthermore, exports of goods in the magnitude of more than 20% compared to GDP go outside the Eurozone for Germany, Austria, Finland, Belgium and the Netherlands. Together these countries account for 42% of Eurozone GDP vs. only 18% for SGIP. Furthermore, these exporters have relatively low fiscal deficits and in turn only a limited need for fiscal tightening. France and Italy face a less positive environment as they have a lower share of exports going outside of the Eurozone but will be impacted relatively more by the loss in demand emanating from SGIP and have higher fiscal deficits.

Euro has been weakening especially vs. competitors

Source: Bloomberg

Moreover, the Euro has weakened considerably on a trade-weighted basis which should give a significant boost to the exporters within the Eurozone and therefore for more than 40% of Eurozone GDP. Besides the weakening of the trade-weighted Euro which is based on trade relationships, the Euro has weakened even more vs. the currencies of key competitors. For example the direct trade relationships between the Eurozone and Japan are limited (accounting for 2% of all exports in goods and 3.5% of imports), but Japan is a key competitor in important industries such as cars and machinery. The fall by roughly 30% in the EURJPY cross rate over the past two years means that Eurozone exporters have become significantly more competitive in a short time-period. In turn, Eurozone exports should profit not only from Eurozone goods & services having become cheaper for its trade partners (or alternatively Eurozone corporates being able to increase their margins), but also that Eurozone goods have become much cheaper vs. close substitute products. Both factors should act to boost demand for Eurozone exports.
Consequently, we are likely to face a Eurozone economy where 18% (SGIP) will remain in a longer-lasting recession, 42% (the exporters) face strong external demand and Italy/France (accounting for 38% of GDP) will be able to muddle through. So far, the Eurozone’s current account has been close to zero amid very high deficits in Spain, Portugal, Greece and to a lesser extent France counterbalanced by substantial surpluses in Germany and the Netherlands. Going forward, the Eurozone current account promises to move into a significant surplus amid significantly lower deficits in Portugal, Spain and Greece and very high surpluses in Germany, the Netherlands and to a lesser extent, Finland, Austria and Belgium.

Intra-Eurozone competitiveness: A solvable task

Much has been written about the unsolvable problems for Spain, Greece, Ireland and Portugal which ultimately can only be dealt with via default. Additionally, the enacted austerity measures have been condemned as hurting growth and therefore increasing the debt burden, raising indebtedness even further. However, one should not forget that these countries essentially face two challenges: Over-indebtedness (mostly of the sovereign in Greece and mostly of the private sectors in Spain and Ireland with a mixture in the case of Portugal) as well as low competitivity. Yes, austerity measures depress near-term nominal growth and in turn raise indebtdedness further, however, they help to restore competitiveness.While the road ahead for Greece appears particularly challenging, there is a high probability that Spain, Ireland and Portugal will manage to solve most of their problems over a 3-5 year time period.
It is frequently stated that SGIP need an internal devaluation in the magnitude of 20-30%. However, this estimate appears wrong on several counts. They are usually derived by comparing the development of nominal unit labour costs (ULC) in Germany with those in SGIP. For example, nominal unit labour costs increased by approx. 8% in Germany since 1999 whereas they increased by approx. 36% in Greece. This suggests that Greece has lost 28% in competitiveness vs. Germany and hence needs an internal devaluation of the same magnitude.
However, one should not forget that Germany joined the Eurozone at an uncompetitive exchange rate. It took Germany several years to restore competitiveness vs. the other monetary union members which was one factor for its weak economic performance early last decade. Assuming that Germany had re-established competitiveness by the end of 2003, reduces the gap in nominal ULC between Greece and Germany to 15% (and 14% for Spain and Ireland and 13% for Portugal). Finally, SGIP need not restore competitiveness vs. Germany but rather vs. the average of the Eurozone. Nominal unit labour costs in SGIP since 1999 increased by 34% whereas ULC in the rest of the Eurozone increased by approx. 21% (see chart below). The difference between these two developments is substantial but not insurmountable. SGIP either need a reduction in nominal unit labour costs of 10% or the rest of the Eurozone needs an increase in nominal ULC of 11% to restore competitiveness in SGIP. More likely though is that we will get a mixture of the two, falling ULC in SGIP and rising ULC in non-SGIP.

Nominal Unit Labour Costs in SGIP vs. the rest of the Eurozone

Source: Research Ahead, Eurostat

The development of Eurozone country inflation rates suggests that the re-adjustment process has already begun. As the chart below shows, inflation in Spain, Portugal and Ireland (grouped together according to their GDP-weight) dropped into negative territory. More importantly, inflation rates are significantly below those in the rest of the Eurozone. Only Greek inflation is headed in the wrong direction. Greece has clearly more work to do and its outlook remains uncertain even beyond the 3-year lifeline provided. However, Spain, Ireland and Portugal have the ability to restore most of the competitiveness lost within the next 3 years. At the same time the announced austerity measures go a long way in bringing fiscal deficits to much lower levels and in turn restore debt sustainability. The price these economies will pay is negative nominal growth as well as a higher sovereign debt to GDP ratio (which will prove sustainable once fiscal deficits have been reduced and given the relatively low starting point especially in Spain and Ireland).

Inflation developments: SIP have already started to restore competitiveness

Source: Bloomberg, Research Ahead

In turn, we will face a divided Eurozone, a longer-lasting recession with negative nominal growth in SGIP and an export-led growth rebound in the North-East which should take both their real growth and inflation rates into the 2-3% range. Current account deficits in Spain, Portugal and Greece should shrink whereas surpluses in the North-East will rise, leading the overall Eurozone into a significant surplus. In turn, the burden of the necessary adjustment to restore competitiveness and debt sustainability in SGIP will not only fall on the SGIP themselves (via deflation) but also on the north-eastern Eurozone economies (via a somewhat higher inflation in the medium term).

Wirtschaftswunder 2.0

The vulnerability of the rest of the Eurozone to sovereign defaults in SGIP is extremely high amid substantial holdings of government debt in the financial sector. However, this danger has been averted for now. On the other side, the real economic fall-out from a long-lasting recession in SGIP should be limited amid low trade flows. For Germany, the combination of historically low nominal and especially real yields and a weaker exchange rate on the one side coupled with the structural reforms performed during the last decade and the high competitiveness being enjoyed by the corporate sector will help growth to become increasingly stronger. Exports are already surging ahead and there is a high probability that domestic demand growth will increase over the medium term from the subdued levels of the past decade. Watch out for growth exceeding 2.5% on average for the next several years.

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