Does the Government-Spending Freeze Mean a Cold German Economic Winter?

Every now and then, we see a bit of economic news that, in our view, not only shows where the financial news world’s biases are, but also how those biases can reduce expectations and build a tall wall of worry for stocks. The latest example: the recent news Germany will freeze public spending for the rest of this year—and may have to tighten the purse strings.^[i] The move follows the Constitutional Court’s ruling that the government can’t repurpose unspent COVID relief funds for its green energy transition.^[ii] Financial commentators we follow claimed that without this spending, not only will Germany’s economy stay weak in the near term, but it will flounder over time, starved of investment in cutting-edge industries. Given this backdrop, it seems to us it won’t take much for reality to beat expectations, which can deliver positive surprise that helps buoy stocks.

In our experience, many think Germany’s economy is predominantly heavy industry-based and state-directed. Not in the communist sense where the state literally owns all business entities, but in the official industrial strategy sense, with the government picking development avenues, directing public money there and enjoying the fruit as private investment follows. It might be a nice story if you are into heavy-handed governments directing economic traffic, but it isn’t true, in our view. For one, the service sector represents a much larger share of output at 62.7% of gross domestic product (GDP, a government-produced measure of economic output) versus 18% for manufacturing.^[iii] Two, Germany’s government doesn’t play an outsized investment role. In 2022, private investment was nearly eight times public.^[iv] That ratio is far greater than the US, where private investment is just over five times public.^[v] So if the US deserves its reputation as a private sector-led juggernaut, we daresay Germany deserves similar accolades.

So may we offer you another take on the recent news about Germany freezing spending this year and facing the prospect of raising taxes or cutting projected spending from next year on? Let us assume Germany leaves taxes as-is, which seems to us the likelier scenario given households are already dealing with high energy costs and inflation, not to mention deep gridlock within the coalition government.^[vi] What if cutting planned investments and expenses doesn’t stagnate the economy, but rather frees up room for the economy to develop naturally, with the market’s invisible hand directing more private investment to its best, most productive uses? And what if those uses aren’t necessarily confined to whatever politicians and lobbyists think is ideal in the name of climate change, but rather endeavors that will make the entire economy more productive, innovative and energy-efficient over time? We aren’t trying to start a debate over environmental issues, but based on our research, there is a long history showing governments aren’t great at picking winners and losers. In our view, the slide in clean energy stocks and rising number of cancelled projects in the field recently suggests that may apply here, to at least some extent.^[vii]

That is the longer term. As for the nearer term, we are sceptical that lower spending changes much. Government spending has dragged on GDP lately, falling alongside consumer spending.^[viii] Private investment has risen year-over-year in five of the past six quarters—barely, but it is up—whilst public investment fell in four of six.^[ix] So the government hasn’t exactly been doing the heavy lifting, and in our view, a modest turnaround in private activity would probably suffice to put Germany’s economy in the recovery column.

Which is where we think the handwringing over a potential public sector pullback is good news—it likely drags expectations even lower, making it that much easier for reality to clear the bar and deliver positive surprise. Commentators we follow had shifted the proverbial sick man of Europe moniker to Germany months ago. Now they view the country as even sicker. It looks to us like a situation where not as bad as feared would qualify as positive surprise, to say nothing of a recovery taking root.

And that recovery seems likely to us. Energy costs may not have erased their entire rise since late 2021, but they are much lower than this time last year, which can make life easier for households and businesses.^[x] Factories and chemical plants—which rely on natural gas as feedstock—aren’t dealing with the shortages that hampered output last winter.^[xi] Costs are down for services businesses, too, whilst households are regaining purchasing power as wages slowly catch up with inflation.^[xii] Germany may not lead the pack. It may not even lead Europe, as has been true the last several quarters.^[xiii] But we think growth in Europe and throughout the developed world should help pull it along—and in our view, that should be enough for stocks.