Germany – A High-Beta Play on the Euro

In April, Morgan Stanley upgraded the 2015 German growth forecasts from 1.1% to 2.1%. Since then, MS had a few disappointments, which suggest that they might have become a bit too optimistic

In April we upgraded our 2015 GDP growth estimate aggressively from 1.1%Y to 2.1%Y on the back of an outsized upside surprise in 4Q14 GDP, signs of strong momentum in 1Q15 and a more favourable macro backdrop due to lower energy prices and a weaker euro. We also raised our 2016 forecast from 1.8%Y to 2.5%Y. For this year, the forecast upgrade is very much down to consumer spending. Next year, it is broad-based, including investment spending and net exports. However, we had a few disappointments since the upgrade, which suggest that we might have become a bit too optimistic.
In many ways, Germany is a high-beta play on the euro: Not only does the German economy sport an industrial sector that has roughly twice the size relative to the overall economy than in the rest of the euro area, but it also has more exposure to economic trends outside the euro area than most other euro area countries thanks to its global export orientation and its multinational companies. As a result, Germany should benefit more from the weaker EUR.

Domestic demand is not held back by a need to de-lever private sector balance sheets or to consolidate public sector finances. Instead, consumers have become the main pillar of growth as they are benefitting from falling oil prices, higher pension benefits, robust employment growth and faster compensation growth. A good part of the increase in compensation growth is due to new minimum wage legislation that came into force at the beginning of the year. First indications suggest that the minimum wage has led to sizeable price increases in selected sectors (e.g., taxis or dry cleaning), but not to a widespread upward push in inflation.

While overall employment has continued to expand robustly, so-called mini-jobs have started to contract as this form of employment has been made much less attractive by the minimum wage. At 4.8% of the labour force, the unemployment rate has likely inched past the NAIRU of 5.25%. As a result, it looks likely that the output gap will vanish soon and pressure on capacity will rise over the course of the forecast horizon.

Investment spending should be supported by favourable financing conditions, surging corporate earnings and rising capacity utilisation rates. That said, geopolitical tensions, Grexit concerns and sluggish demand growth in other large euro area countries still seem to dent investment in machinery and equipment. A wait-and-see attitude among German corporates is also indicated by banks reporting falling corporate credit demand.

Construction investment benefitted from several factors, including unusually warm winter weather, rising house prices, record-low mortgage rates and plans for an expansion in government-financed infrastructure investment later this year. Given the even better-than-expected outturn for the 2014 budget balance, at 0.4% of GDP, the government has space for fiscal policy expansion. But so far only some timid steps to increase infrastructure investment are planned. Due to strong domestic demand, net exports will likely only contribute modestly to overall GDP growth: That said, the much-debated trade balance surplus will likely rise materially due to the sharp fall in import costs (notably for oil). As a nation with a major current account surplus, Germany continues to be a big capital exporter and over the years has accumulated sizeable exposure to the rest of the world, in particular the euro area. Through this financial stability channel, Germany is a high-beta play on the euro as well.

Elga Bartsch – Global Co-Head of Economics & Chief European Economist – Morgan Stanley