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A First Class Cabin on the Titanic?

23 Nov 2011

It has come down to the starkest of choices: euro break-up or fiscal union. It’s a decision that few in Germany want to make, but time is running out for Europe’s leading economy to make its mind up. Philip Moore reports.

Who would be brave (or barmy) enough to launch a new European equity fund in today’s intensely volatile and unpredictable environment? SW Mitchell Capital (SWMC) would. Hours after Greece threw its referendum spanner into the European works, the London-based European equities specialist announced the launch of a new mid/large cap European fund.

Granted, the SWMC fund can express itself through short as well as long positions. But Stuart Mitchell, founding partner and investment manager at SWMC, says the fund will have a long-bias towards core Europe in general and towards Germany in particular. "German exports are more competitive than they have been for 20 years," he says. "Exporters of machine tools and other engineering products are winning market share in booming emerging markets from Japanese, Korean and American companies."

"What I also think will be a very interesting theme over the coming five or 10 years is that at some stage the German domestic economy is going to make a strong recovery," Mitchell adds. "Property prices are at a similar level to where they were 15 years ago and consumer spending has barely moved in the last 10 years. When domestic demand recovers, it will be a big driver of the European economy."

Mitchell’s views on the European corporate scene are worth listening to, his long-only European equity fund having returned an annualised 11.5% since 1998. He also knows a bit about buying equities on the dips, having started his career at Morgan Grenfell Asset Management (MGAM) on Black Monday, 1987.

Mitchell’s views on the fundamental strength of the German economy are also shared by a number of economists. "In principle the fundamentals of the German economy remain sound," says Jörg Krämer, chief economist at Commerzbank, basing his assessment on a number of persuasive arguments.

One of these is the competitiveness of German industry measured by unit labour costs, which Krämer says have remained virtually flat since the launch of the single European currency. In large measure, this reflects what he describes as the internal flexibility of the labour market and the preparedness of the unions to compromise on wages and working hours. This has helped to underpin what Krämer says has a been a "paradigm shift" in the labour market, which has now reversed the upward trend in unemployment which began after the first oil shock in 1973.

One result of this structural shift, says Krämer, is that domestic demand is already playing an increasingly decisive role in the German economy. Others agree. Dr Norbert Irsch, chief economist at KfW in Frankfurt, says that while export growth is projected to fall by almost two-thirds in 2012, private consumption is expected to hold relatively steady, at around 1% according to the consensus. "A private consumption growth rate of about 1% is very strong for Germany, because since 2000 even in good years we have seldom seen rates higher than 0.6%."

Krämer says that these trends, coupled with elements such as Germany’s high savings rate, the absence of any overheating in the real estate market and exceptionally low interest rates should all combine to ensure that Germany continues to outperform the rest of the Eurozone for many years.

In an era of economic and political stability, this would all amount to a very compelling reason for buying most German assets, although Mark Dowding, co-head of investment grade credit and portfolio management at BlueBay Asset Management, says that he favours German corporate bonds over Bunds. "At current low yields there is a 35%-40% chance that Bunds will generate a negative return over the next 12 months," he says. "With German corporate balance sheets in such good shape, there is a case to be made that investment grade credit may be a better place for safe haven investment flows."

All hands on deck

The very obvious snag is that this is anything but an era of economic or political stability. The consequence is that in a European context Germany may well be sitting in the first class cabin. The danger is that it will turn out to be like being in the first class cabin of the Titanic.

Even if the German economy is fundamentally strong enough to steer its way around any icebergs that lie in its path, the associated danger is that collective angst about the outlook for Europe becomes a self-fulfilling prophecy.

Andreas Rees, German chief economist at UniCredit in Munich, says that he does not see a post-Lehman style recession unfolding in Germany next year, and is pencilling GDP growth in 2012 of 1.2%. "German companies are still sitting on a huge pile of backlog orders and the upward trend in job creation is consistent with moderate GDP growth," he says.

A potential roadblock, however, is negative sentiment driven by the havoc unfolding elsewhere in the eurozone. "The biggest unknown quantity both in Germany and elsewhere in Europe is risk aversion spreading over from financial markets into the real economy," says Rees. "The biggest downside risk is that current news coming from Greece and elsewhere in southern Europe will lead consumers and companies to play it safe, postponing the purchase of durables and putting investment plans on hold."

Some evidence of this may already have started to emerge. After 19 months of continuous declines, the German unemployment rate rose unexpectedly in October. The number of unemployed rose by a seasonally-adjusted 10,000 to 2.94m, compared with expectations of a decline of 10,000, lifting jobless rate by 0.1% to 7%. Although Rees cautions against reading too much into a lagging indicator, others say that these dispiriting numbers suggest that Germany’s apparent immunity to the fault lines opening up elsewhere in Europe may be near or past its shelf-life.

Some economists do not deny how serious those fault lines have become. Brendan Brown, head of economic research at Mitsubishi UFJ Securities International, paints a stark picture in a recent edition of his Daily Economic Viewpoint. "The Old Bundesbankers... who warned against the nightmares of EMU would be shocked by just how bad Germany’s monetary and wider fiscal predicament has become in consequence of European monetary integration," Brown commented in early November.

Mike McNaught-Davis, head of international equities at Scottish Widows Investment Partnership (SWIP) agrees that the central conundrum for Germany is the apparently irresolvable conflict between the strength of its fundamentals and corporate sector and the exogenous pressures created by the eurozone crisis. "Purely at a company level there are some very attractive investment opportunities in Germany," he says. "Look at the recent results from BMW which were well ahead of forecasts. The problem for Germany is contagion from elsewhere in Europe which seems to be spreading like gangrene."

McNaught-Davis and others say that it is looking increasingly clear that there are likely to be two endgames to the crisis, neither of which will be palatable to Germany. The first of the two would involve some form of dismantling of the euro, with some commentators foreseeing the creation of a northern European version of the single European currency. For Germany, that would be catastrophic in the short term, because the strength of a currency created from an improbable German-Austrian-Dutch monetary alliance would be such that it would risk bringing German exports to their knees.

As KfW’s Irsch points out, while Greece, Portugal and Ireland account for an almost negligible share of German exports, Spain and Italy are key contributors to Germany’s current account surplus. "The eurozone accounts for 40% of German exports, which shows how dependent we are for growth on our partners in Europe."

Small wonder, then, that according to German economists, a breakup of the euro would be a horror story that is not being countenanced by the majority of Germans. "The man on the German street is confused and irritated by what is happening in Greece," says Rees. "But there is very little appetite for a wholesale rejection of the euro project. This option isn’t even on the table in Germany."

Really? Why, then, is the tour operator Tui, which sends millions of German tourists to Greece, reported to have begun renegotiating contracts with Greek hotels based on drachma payments?

The second of the two possible endgames is likely to be equally damaging to Germany. "The other option is fiscal union which would lead to Germany pouring billions into the eurozone and jeopardising its own economy in the process," says McNaught-Davis. In that outcome, the €211bn that Germany has agreed to provide as a guarantee to the European Financial Stability Facility (EFSF) would begin to look like pocket money.

Vulnerable rating

Over the longer term, that would provide more ammunition to those who have already argued that Germany’s triple-A rating is vulnerable. Most notably, Citi’s Willem Buiter warned in August that "even Germany has to look over its shoulder, with an 80% of annual GDP government debt ratio, as its deficit improvement has been flattered by unsustainable cyclical growth which is now petering out."

Buiter’s note added that neither Germany nor France met the general government deficit target specified by the Maastricht Treaty in six of the 12 years between 1999-2010. Germany, meanwhile, failed to meet the debt to GDP ratio prescribed by Maastricht in 10 of those years.

Others are more relaxed about the short term outlook for Germany’s rating. "S&P’s principal concern when it downgraded the US was the trajectory of its debt and the inability of its politicians to reverse it," says Dowding at BlueBay.

"By contrast, Germany has some very robust balanced budget legislation, so we would expect the debt to GDP ratio over the medium term to trend lower, rather than higher. Of course that would be jeopardised if Germany were required to formally guarantee other eurozone members’ debts, but we think this is unlikely. We think a more likely outcome would be a gradual acceptance of the ECB as lender of last resort."

Perhaps. But others warn that long-term pressures would continue to build on Germany’s economy and on its public finances even in the absence of the debt crisis. Commerzbank’s Krämer says that implicit government debt, adjusted to reflect pension liabilities, is probably close to 200%. This would suggest that Germany’s rating will come under threat in the very long term, especially as demographic trends are likely to limit its growth potential.

"The main structural challenge that will hit Germany in the long term is the shrinking and ageing of the population," says Irsch at KfW. "This will reduce Germany’s annual GDP potential growth from 1.6% today to 0.8% in 2030 if we don’t implement counter-measures."

23 Nov 2011