Germany: is the eurozone’s growth engine stalling?

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A banking crisis, a sovereign debt crisis, an existential crisis. That was the easy part. After weathering multiple disasters, the spectre of a regional growth crisis that threatens to further exacerbate the region’s woeful debt burden has come to the fore after the shock contraction in German growth in the fourth quarter.

Long insulated from the eurozone crisis in GDP terms, news that the German economy probably contracted by 0.5% in the final quarter of last year was a reminder that despite the financial markets’ euphoria over the euro’s survival, the region’s growth engine is sputtering, even as markets rise. The decline took GDP growth for 2012 down to 0.9% from the red-hot 3.1% in 2011, according to the German statistical authority. Analysts say that while the domestic economy is still performing well, the slowdown was driven by a fall in export growth that shows Germany GDP is no longer immune from the region’s weakness. “Uncertainty about the outlook for the eurozone and the health of the German growth motor have resurfaced,” says Natascha Gewaltig, director of European economics for Action Economics. The breakdown showed the slowdown was mainly due to a drop in investment, with gross fixed capital investment down 5.2% on last year. “Machinery and equipment investment dropped sharply, which is hardly a surprise in the light of the escalation of the debt crisis and the uncertainty about the future of the eurozone,” says Gewaltig. However, the impact from the continued weakness outside its borders was offset by continued strength within the domestic economy. Timo Klein, senior European economist at IHS Global Insight, says that rebounding leading indicators since November, particularly the IFO business survey and purchasing managers’ index (PMI), suggest that the fourth-quarter dip should prove a “one-off event”. “Income continues to be bolstered by resilient employment developments and strong wage growth, and consumers’ savings propensity is kept very low by fears about putting funds into financial investments,” he says. “German domestic demand has developed enough intrinsic momentum, and non-European external demand is robust enough to limit the fallout of the crisis.” The composite PMI of the construction, manufacturing and services sectors accelerated from 50.3 to 53.6, a 12-month high on a scale where any number more than 50 represents expansion. Graham Turner, head of the consultancy GFC Economics, says the rebound could well reflect the bounce in demand from non-EU countries, pointing to IMF data showing that 26.9% of exports went to developing countries, the highest since records began in 1981. Nevertheless the IMF last month did shave 0.3 percentage points off its outlook for German growth this year to just 0.6%, as it cut eurozone growth by the same margin to minus 0.2%. Furthermore, it was a 1.7% month-on-month drop in retail sales in Germany in December that dragged down overall eurozone retail sales to minus 0.8%, even though consumers should be best placed to spend due to high employment and rising real income.
German chancellor Angela Merkel
Germany, much to chancellor Angela Merkel's despair, also faces longer-term threats from an ageing population that could create skills shortages. A recent report by the OECD warned that the country’s labour force would contract by 4% during the decade to 2020. Launching the report, Yves Leterme, deputy secretary-general of the OECD, said Germany’s prosperity depended to a “considerable extent” on whether it managed to remain competitive despite its ageing population. In the short term, however, investors retain confidence in Germany’s outlook. It is the only country in the eurozone and one of the few in the world to have an AAA credit rating with a stable outlook from Standard & Poor’s. However, even that rare distinction might be under threat. Rival agency Moody’s put Germany on a negative outlook in July. Ten-year German bunds now yield around 1.6%, up from 1.2% last summer, while Spanish yields, which moved above 7% in 2012, have fallen below 5.2%. According to Cosimo Marasciulo, head of government bonds and FX at Pioneer Investments, the threat comes from convergence between Germany and peripheral economies such as the Piigs – Portugal, Italy, Ireland, Greece and Spain. “There will be more fiscal integration in Europe and countries will need to give up some fiscal sovereignty, so there will be a convergence of credit ratings across Europe. “Clearly, the AAA countries in this convergence process will gradually lose some of their AAA status but the timing is extremely difficult. However, the medium-term story is clearly for higher German rates.” Last week’s decision by Fitch Ratings to reduce its outlook for the Netherlands, one of the few remaining AAA eurozone members, from stable to negative might turn out to be a harbinger. Marasciulo, who is also co-manager of Pioneer’s €1.45 billion Euro Aggregate Bond Fund, says investors need to remember that buying German bunds “implicitly” exposes them to peripheral countries via the EU bailouts, the European Financial Stability Facility and the ECB’s balance sheet expansion through Target2. He calculates the exposure at 25% of German GDP. But what if Germany were to lose its AAA stable outlook? “I don’t think that alone a negative outlook would be enough to force investor selling,” says Marasciulo.

“You need a loss of confidence and investors asking why they should keep this low-yielding security, which might not be a robust AAA in the future, when I can buy high-yielding securities.”

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