Putting Germany’s Q2 Contraction Into Perspective

-0.1%. 0.2%. 0.4%. -0.1%. These, in chronological order, are Germany’s real, quarter-over-quarter gross domestic product (GDP, a government-produced estimate of national economic output) growth rates in each of the past four quarters.^[i] According to some headlines from financial publications we regularly review, Q2’s dip is a sign Germany’s “golden decade” is ending and recession is nigh. Never mind that when GDP shrank by the same percentage in Q3 2018, it snapped back and grew in each of the next two quarters. We think that should be your first clue that Q2’s wee contraction is neither predictive nor automatically the end of the line—for Germany’s economy, the world or equity markets.

A popular theme amongst news outlets we read is that German weakness results from Brexit dread and the US and China’s trade war. Pundits cite Germany’s export-heavy economy and claim these trade headwinds are severe threats, citing German exports’ -1.3% q/q decline in Q2, which the country’s federal statistics office described as the worst result in six years.^[ii] Industry analysts we follow see falling car demand in China, connect it to the trade spat, and pen laments for Germany’s vaunted automakers. Some in our perusal of the financial press acknowledge Germany’s services sector is chugging along fine, but they warn weak manufacturing is a bellwether and malaise will soon befall the entire country. At first blush, household spending growth’s sharp slowdown from 0.8% q/q in Q1 to 0.1% q/q might seem to support this viewpoint.^[iii] So might gross fixed capital formation’s -0.1% q/q decline, although negativity here was confined to the construction sector—investment in machinery and equipment and other products rose.^[iv] With financial pundits widely considering Germany the eurozone’s pillar of strength, many presume it is only a matter of time before the broader eurozone economy gets sucked into the vortex.

Now, economic data are seldom black and white, and we think there are kernels of truth in some of these claims. German exports to the UK stumbled in Q2, a likely sign of Brexit uncertainty’s international reach.^[v] Several reports have shown that when Brits thought Brexit would happen on 29 March and feared it could be a no-deal exit, they stockpiled goods—including finished goods and components from Germany and other eurozone trading partners. When Brexit got delayed, Brits could work through them without needing to send German suppliers new orders. This likely isn’t a long-term headwind, as events like this usually just pull demand forward temporarily, in our view, but it probably was a factor in Q2.

We think China was too, in all likelihood—but not necessarily because of the trade war. A batch of recent Chinese data also showed private sector investment and demand remain rather weak, a likely sign the government’s stimulus measures haven’t fully hit the economy yet, in our view.^[vi] We don’t think those stimulus measures have much to do with the trade spat, though. Rather, in our view, they were necessary to offset the government’s 2018 crackdown on “shadow banking,” or financing that occurs outside the traditional banking sector. Statements from various Chinese policymakers indicate regulators, concerned about ballooning off-balance sheet debt and local government finances, shut off these funding avenues—and measures of corporate financing show this starved small private firms of funding in the process.^[vii] Officials’ stated purpose for many of this year’s stimulus measures was to goad traditional banks into finally serving these companies, but we think they will take time to bear fruit.

As for China’s weak auto sales, data show they don’t really mesh with trade war timing. Auto sales turned negative last May, four months before President Trump’s first round of tariffs on Chinese goods (and China’s retaliatory tariffs against some US goods) took effect.^[viii] In our view, to argue it was an early indicator of tariffs’ bite is to argue consumers don’t try to front-run new taxes by pulling sales ahead of them, and that Brits’ efforts to front-run March’s no-deal Brexit that didn’t happen. If tariffs were the culprit for falling Chinese auto sales, then we suspect auto sales would have started falling in late 2018. Their earlier slide, in our view, is another indication the alleged cause-and-effect narrative doesn’t add up.

Besides, China isn’t Germany’s only customer. Auto sales have weakened in much of the world, including America, in recent months.^[ix] This is a normal part of the economic ebb and flow, particularly in a maturing expansion, according to our historical analysis. But it probably doesn’t need to knock Germany flat. Germany’s auto sector is relatively big compared to other countries. Gross production value, about €500 billion annually according to Statista, is about 14% of annual GDP.^[x] But that also leaves about 86% of Germany’s economy that isn’t autos.^[xi]

Taking a broader view, heavy industry (ex. construction) is 23.2% of annual output.^[xii] Services add up to 68.2%.^[xiii] So whilst manufacturing may wobble enough to pull GDP negative now and then during an expansion, the service sector probably dictates the country’s performance in the longer term, simply due to its sheer size. We think this should be a relief, because available evidence suggests Germany’s service sector is growing. July’s services purchasing managers’ index (PMI) hit 54.5, better than the US’s (readings over 50 indicate expansion).^[xiv] Whilst manufacturing has been in contraction for months, services have broadly strengthened this year.^[xv] IHS Markit, which conducts PMI surveys in Europe, reports new business is still on the rise among German service firms, fuelled by domestic activity.^[xvi]

In our view, investors should stay cool and remember equity markets typically move most on the gap between reality and expectations. The latter—expectations—are seemingly falling toward rock bottom right now. We don’t think it should take much in the way of good news for equities to get positive surprises from here.