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Carsten Brzeski’s blog

German Quarterly Economic Update - Q2 2016

New periphery?

At face value, the German economy is still going strong. Beneath the surface of decent growth rates, however, peripheral symptoms are beginning to show.

Solid performance despite turbulent external environment…
Despite another very turbulent year with the Greek crisis, the Chinese slowdown, the refugee influx and increased geopolitical tensions, the German economy continued its solid growth performance with 0.3% QoQ growth in the final quarter of 2015. Looking ahead, the economy should continue its current positive, though not breathtakingly strong, momentum on the back of solid domestic demand. At the same time, however, the number of latent issues and risks are increasing.

…as domestic economy is still an island of happiness
Germany can still lean on a strong domestic economy. The labour market continues moving along the line of its current natural rate of unemployment of c.5% (according to the Eurostat definition). At the same time, the number of baby boomers leaving the labour market seems to be offset by immigrants and the non-active labour force, pushing employment from one record high to the next. So far, the influx of refugees has not left any mark on the labour market. Moreover, low energy prices and interest rates are another argument for solid consumption growth this year and beyond. Another round of wage increases this year – we expect another nominal increase of 3% – should also contribute to stronger private consumption. In addition, the service and construction sectors are booming. Particularly the construction sector has experienced another uplift in recent months. In the first two months of 2016, activity in the construction sector has increased by almost 5%, compared with the final quarter of 2015. Building permissions are currently at their highest levels since 2006.

 

 

Former growth engines are struggling…
While consumption and construction are flourishing, industrial production is currently going through tougher times. In fact, industrial production has become a kind of ‘problem child’ over the last few months. Despite tentative signs of stabilisation, industrial production has stagnated for a long while and, in 2015, recorded the worst performance since 2012. Stagnating industrial production currently goes hand in hand with weaker exports. Though always a reliable growth engine in the past, net exports, on average, did not contribute anything to quarterly GDP growth over the last two years. In 2015, net exports were even a drag on growth. The weaker euro was only partly able to cushion the negative impact from weaker external demand, particularly from China and oil-exporting countries.

 

 

…to gain more momentum
Looking ahead, the outlook for industrial production and exports looks anything but rosy. Foreign orders have dropped by more than 7% since last summer, reflecting a broader weakness in Germany’s main trading partners. Moreover, tailwinds from the weak currency are also fading away. Since late November, the euro has appreciated by more than 6.5% vis-à-vis the US dollar. At the same time, the trade-weighted exchange rate appreciated by some 5%. The only upside for the outlook for industrial production is the recent increase in capacity utilisation and the decrease in inventories.

Short-term outlook remains strong, but home-made risks are increasing…
At first glance, the German economy seems well prepared for another decent growth performance this year. The changing balance of growth drivers is just a natural evolution and part of the mature business cycle the economy is currently in. In the short run, the biggest risks for the economy seem to stem from a sharper global slowdown and increased political uncertainty in Europa, with the latter having clear repercussions for the investment climate in Germany. In the longer run, however, the biggest risk for the German economy is home-made: it is the current complacency, the lack of new reforms and the unravelling of a new political landscape. In early April, the OECD joined the well-known choir of voices, calling on the German government to step up reforms. In our view, the government is currently dragging its feet on the opportunity to implement new reforms in education, healthcare and pensions and to increase public investments in infrastructure (conventional and in high technology) and to push ahead with a faster and deeper integration of monetary union. Particularly the latter could be the trigger for (visionary) investments, not only in Germany, but also in the entire Eurozone.

…and changes to the political landscape are posing new challenges
The government’s efforts to tackle any of the above issues, however, are currently hampered by the ongoing refugee crisis and changes to the domestic political landscape. For a long while, Germany seemed to be immune to nationalistic and populist trends witnessed in almost every neighbouring country. The refugee crisis has changed this. The emergence of the AfD could make the forming of a government more complicated and could require unprecedented coalitions in the future. Generally-speaking, traditional parties are still having trouble finding the right approach to directly engage with the AfD. Eventually, this could either lead to more reform paralysis based on the fear that the AfD could gain more votes or to more reforms and answers to protest votes to take the bull by the horns.

With strong consumption, a booming construction sector, but stagnating industry and exports and a reprimand from international institutions to step up reform efforts, the Eurozone’s largest economy is losing some of its lustre. It is still far-fetched now, but without any new reformist verve, the Eurozone periphery could soon start in Germany.