Tuning up the euro’s engine

Much like that car – although this analogy would be better had it been a BMW – Germany’s economy is no longer firing on all cylinders, and the economic engine of the eurozone is in urgent need of a mechanic.

During the eurozone crisis, the region was neatly divided into the strong core countries, Germany and France, and the troubled periphery of Portugal, Ireland, Italy and Spain. However, this split is becoming less relevant as economic data from Germany shows a startling weakness in the economy which accounts for 27 per cent of the region’s economic output.

The most recent figures on industrial production, factory orders and the forward-looking purchasing managers’ index for manufacturing paint a dismal picture for third-quarter economic growth. After contracting in the second quarter of the year, there is a chance that Germany could fall back into technical recession by recording two quarters of negative growth. But are things as bad as the headlines say?

It is always worth remembering that many economic data series are quite volatile and can show quite large swings from month to month. Because of this it is better to focus on the trend rather than on one particular data point. The very negative industrial production figure from August which caused all the worries was in some respects a pull back on the stronger July number. As the chart shows, the three-month moving average for this series is not as bad as the previous month, and smoothes out some of the volatility, although still the trend is not great.

Some commentators point to the uncertainty generated by the Russia/Ukraine conflict, given Germany’s close economic ties with Russia. The sanctions and subsequent counter-sanctions may have damaged sentiment towards Germany, but the quantifiable impact is limited. For example, last year, Germany’s exports to Russia represented a very small 3.3 per cent of total exports – hardly enough to hold back economic growth. In terms of export-led growth, any signs of a further slowdown in China would be more worrying for German policy makers.

There are always other factors at play, including the timing of public holidays. Did Easter fall in April or March this year? Was there a Royal Jubilee? Even if statisticians adjust data for seasonal factors, there is no escaping the fact that fewer work days equal lower output. In Germany, for example, the summer holidays fell over a slightly different set of days than last year, which compounded some of the weakness already in the data.

So perhaps the short term is not as bad as the market thinks, but if the September data is as poor as August’s there is a good chance that there will be little growth from Germany, and hence also the eurozone, in the third quarter of this year.

More importantly for the eurozone, and those that choose to invest their money in that region of the world, is the long-term outlook for Germany. Much of Germany’s success is based on the strength of its export competitiveness, and the low wages that make this possible. Many argue that wages have not kept pace with the increase in productivity since the early 2000s, but politicians are starting to address this. The country’s first minimum wage law comes into effect at the start of next year, although it will only apply to certain sectors of the economy.

Additionally, Germany will need to revisit its energy policies – Energiewende – as agreed under the coalition government that came into power last year. The decision to close Germany’s nuclear reactors combined with their desire to promote renewable energy sources has led to a sharp rise in energy costs for consumers and an unstable supply for manufacturers, which is hampering their competitiveness.

For a long time, policymakers in Europe have been trying to convince Germany that there was something wrong under the bonnet, and that spending levels should be increased to create a source of demand for other eurozone economies. But German politicians have resisted, focusing instead on the need to balance budgets, although they may not be able to keep this up for much longer, and fiscal leniency is back on the agenda. However, it is not clear whether politicians will listen out for the rattle in the engine or simply turn up the stereo to drown out the noise.

Kerry Craig is global market strategist for JP Morgan Asset Management