The German economy has detached from other developed markets over the past year. Real GDP growth in Germany grew at 3.6% in 2010, and accelerated to 5.5% growth in the first quarter of this year. This morning, we learn that the initial estimate of Q2 GDP growth has fallen sharply to 0.5%. This is the weakest rate of growth since Q1 2009. While much slower GDP growth in the world’s 4th largest economy creates challenges, the abruptness of the decline may serve as a wake-up call to aloof German politicians who think that all of the problems around the rest of the developed world were unique to other places and that German was exempt because of superior fiscal policy choices over the past couple of years. No Way! Here are a few key points:
1) Why Germany has been strong?
Germany has been strong over the past 5 quarters (until Q2) based on net exports. Germany has a strong manufacturing base and a productive economy with a high degree of capital intensity. Exports ran at a 14% growth rate in 2010, and continued at a 9.6% growth rate in Q1. We don’t have the detail yet for the Q2 German GDP print but this was likely to have slowed sharply. A primary reason for German export competitiveness has been a weaker Euro than what a stand-alone currency for just Germany would have been. If Germany had been operating with the Deutschemark, the FX rate would be much stronger, and export growth slower. See the strength of the Swiss Franc to get an ideal of what might have been.
2) Why the impact on global financial markets will be muted?
The German GDP release this morning was for the April-June time frame. The data lag relative to the fast changing economic environment. Importantly, we have an array of company reports for Q2 which were already released that reflect the economic and business environment in Q2. Germany isn’t in a recession, the environment has been stronger than the data indicate and corporate profits geared towards Germany have been strong.
3) The key outcome in Europe relates to the ESFS and the Euro
The European Financial Stability Facility (EFSF) was created in May 2010, within the framework of the Ecofin Council. The EFSF is able to issue bonds to provide loans to EU-17 member states (so far Greece, Portugal, Ireland) and may also intervene in the markets. The EFSF has been assigned a AAA credit rating by Standard & Poor’s and has a higher credit rating than US Sovereign Debt (this is absurd). Weakness in the German economy may get German officials to become more amenable to stimulatory measures to support the European economy. This is more likely because inflation is less of a threat with growth this soft. Moreover, Germany is the best positioned nation in Europe to be simulative with the lowest interest rates (10-YR 2.17%), the highest interest coverage, the smallest deficit to GDP, and a manageable debt/gdp ratio of about 70% (depending upon what debt estimates you use).
Europe tends to be a stickier economy than the US. The economy is more rigid and the labor markets are less flexible. The weak German GDP print will lead us to monitor the higher frequency German economic data closely but DO NOT bring us closer to the view-point of global recession.
Markets are reacting poorly to the quick takeaways from the Merkel-Sarkozy press conference. During the conference they have discussed moving closer together from a political point of view, but have not made specific mention of joint-support for shorter-term funding concerns. None of this is really market moving news as the ECB is still purchasing European sovereign debt (yields are down today) and the ESFS will be expanded this fall. The financial transaction tax to be imposed in September is new. We have yet to see specific details of just what this means – but assume it relates to an attempt to cut down on “destabilizing” high frequency trading. Being advocates and supporters of the free market – Crackerjack doesn’t think the last measure was necessary.
One item to note, some of this selling could be from European institutions who were disappointed with the conference and are selling in the US because European markets are closed. With markets having had the large pullback they did the one thing that matters is whether or not the global economy goes into recession. To gauge this we have focused are attention on 3 things:
1) The US economy leading indicators
2) The China economy leading indicators
3) Avoiding a financial crisis in Europe