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- German economic success since the global financial crisis has been premised on cheap Russian natural gas and Chinese demand for German exports – both are reversing.
- The scope for supply side reforms is limited which suggests that German’s growth trajectory may remain weak for the foreseeable future.
- We find that short euro, German flatteners and short German stocks would outperform in a weak German growth regime.
Everything that could go wrong has gone wrong for Germany this year. But the biggest issue is that Germany’s economic model appears to have fallen apart. Simply put, in the past, Germany has used cheap Russian energy to make exports for China. This has allowed German growth to surge since 2008 and its current account surplus to balloon (Charts 1 and 2). Now the energy source is fast disappearing and China is struggling to generate any domestic demand.
On the gas front, it is notable how low and stable natural gas prices were between 2009 and 2019 – i.e., from the global financial crisis until COVID (Chart 3). This occurred even as crude oil prices saw sharp rallies during this period (Chart 4). But with the onset of the Russia-Ukraine war, the natural gas supply to Germany has started to dwindle. The latest salvo has been a further reduction of supply through Nord Stream 1, which could leave Germany running out of gas by March 2023 (Chart 5).
If that wasn’t enough, the Chinese economy has been spluttering since COVID. This is a problem for Germany as almost two-thirds of German growth between 2009 and 2019 came from net exports. And the key export market is China. It’s share of German exports grew from 2% in the early 2000s to almost 8% just pre-COVID – comparable to the US share (Chart 6). However, since the pandemic, progress there has deteriorated significantly . Our China growth tracker has been showing weak growth for the past year. But even official data is showing weakness – both nominal and real GDP growth have been collapsing which suggests recessionary conditions (Chart 7). While fiscal and monetary stimulus may boost growth in the near-term, structural issues in China suggest their impact will be much more limited than before.
Labour Market Problems
In the past, the fall-back for Germany has been its labour market. In the early 2000s, Chancellor Schroeder enacted the Hartz reforms which help lower labour costs. This along with the introduction of the euro, which prevented other countries devaluing against the German mark , helped give Germany a competitive edge over other European countries. This was one reason why the German current account started to grow in the 2000s.
But all that changed after the global financial crisis as German labour costs picked up again. Indeed, between 1999 and 2007, German unit labour costs were flat compared to Italy’s 26% jump (Chart 8). Yet between 2009 and 2019, German costs jumped 24% compared to Italy’s 10%. Since COVID, German costs have continued to outpace other European countries’.
With an unpopular Chancellor (Scholz), and a fractious coalition government, it’s hard to see any impending labour market or other structural reforms to replace the cheap energy/China export model that Germany has relied for the past decade.
How to Play German Weakness
Timely indicators such as the German IFO or consumer confidence surveys are all showing weakening growth (Chart 9). Therefore, both the near-term cycle as well as the structural problems are aligned. Looking at which markets are most sensitive to German growth, we find the euro, the German yield curve and German stocks all to be positively correlated to growth (Charts 10 to 12, Table 1). The strongest relationship appears to be with stocks, though it also has moved a lot already. Nevertheless, we would opt for a combination of short euro, German 2s10s flatteners and short German stocks to play this theme.