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 GDP growth rates in each of the past four quarters.^[i] To hear headlines tell the tale, the most recent result—announced Wednesday—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 reached new heights in each of the next two quarters. 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 stocks.

The popular narrative claims Germany is collateral damage from Brexit dread and the US and China’s trade war. Pundits cite Germany’s export-heavy economy and claim these headwinds to trade are severe threats. Industry analysts see falling car demand in China, connect it to the trade spat, and pen laments for Germany’s vaunted car industry. Those who acknowledge Germany’s services sector is chugging along fine warn weak manufacturing is a bellwether and the entire country will soon catch the malaise. With Germany widely considered the eurozone’s pillar of strength, most presume it is only a matter of time before the broader eurozone economy gets sucked into the vortex.

Nothing is ever black and white, and there are kernels of truth in some of these claims. German exports to the UK stumbled hard in Q2, a sign of Brexit uncertainty’s international reach. When Brits thought Brexit would happen on March 29 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 had unnecessary stockpiles to work through, relieving them of the need to send German suppliers new orders. This isn’t a long-term headwind, as events like this usually just pull demand forward temporarily, but it probably was a factor in Q2.

So was China, in all likelihood—but not necessarily because of the trade war. A raft of Chinese data also out Wednesday showed private sector investment and demand remain rather weak, a sign the government’s stimulus measures haven’t fully hit the economy yet. Those stimulus measures don’t have much to do with the trade spat, though. Rather, they were necessary to offset the government’s crackdown on “shadow banking” last year, or financing that occurs outside the traditional banking sector. Regulators, concerned about ballooning off-balance sheet debt and local government finances, shut off these funding avenues—and starved small private firms of funding in the process. Many of this year’s stimulus measures aim to goad traditional banks into finally serving these companies, but they will take time to bear fruit.

As for China’s weak auto sales, this doesn’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. 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, much as Brits tried to front-run that no-deal Brexit that didn’t happen. If tariffs were the culprit for falling Chinese auto sales, then we would expect said auto sales to start falling in late 2018. Their earlier slide, in our view, is another indication the alleged cause-and-effect narrative doesn’t add up.

Plus, China isn’t Germany’s only customer. Auto sales have weakened in much of the world, including America, in recent months. This is a normal part of the economic ebb and flow, particularly in a maturing expansion. But it doesn’t need to knock Germany flat. True, Germany’s auto sector is big. Gross production value, about €500 billion annually according to Statista, is about 14% of annual GDP. But that also leaves about 86% of Germany’s economy that isn’t autos.

Zoom out a little more, and heavy industry (ex. construction) is 23.2% of annual output. Services add up to 68.2%.^[ii] So while 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. This should be a relief, because available evidence suggests Germany’s service sector is growing fine. July’s services purchasing managers’ index (PMI) hit a robust 54.5, ahead of the US (readings over 50 indicate expansion). While manufacturing has been in contraction for months, services have broadly strengthened this year. IHS Markit, the keeper of all things PMI in Europe, reports new business is still on the rise among German service firms, fueled by domestic activity.

Now, in discussing a major country’s GDP, we would usually parse the details—what contributed, what detracted, etc. But we can’t do that today as no such detail yet exists. Beyond the German Federal Statistics Office’s vague rhetorical description, Wednesday’s report was devoid of detail. So all the analysis swirling today about exports tanking and crushing Deutschland revolves around one simple sentence: “The development of foreign trade slowed down economic growth because exports recorded a stronger quarter-on-quarter decrease than imports.” A little flimsy, in our view. That is one reason we think it is important not to jump to conclusions—especially here comes a global recession conclusions. Besides, this looks most like a sentiment-driven overreaction to backward-looking data. Which, like the steep volatility off record highs hit just a couple of weeks ago, seems much more correction-like than bearish.

So stay cool and remember stocks move most on the gap between reality and expectations. The latter—expectations—are falling toward rock bottom right now. It shouldn’t take much in the way of good news for stocks to get positive surprises from here.