Germany & the Eurozone

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Global markets have experienced another volatile week, buffeted again by concerns centered in the Eurozone.  Developments in Germany were an important factor.  Our friends at Action Economics have written about the “stability anchor” role played by Germany, as the largest economy with the most robust growth, strongest fiscal position, most liquid bond market, and a history of prudent economic and financial policies. Thus, it is not surprising that global markets react sharply to any negative developments in Germany.  While some of the current concerns seem exaggerated to us – such as the rumor that Germany could face a near-term ratings downgrade – other concerns do worry us significantly.

One set of concerns relates to the current state of and prospects for the Germany economy, the recent growth leader among the largest advanced economies.  Clearly, the German economy has slowed.  Germany’s GDP barely advanced in the second quarter, up just 0.1% over the first quarter.  Advance data for the current quarter present a mixed picture.  The demand for manufactured goods is strong; orders were up in June. On the other hand, industrial production declined.  The slowdown in the global manufacturing cycle this year is, no doubt, a serious headwind for German export growth. 

In addition, there has been a palpable decline in confidence in Germany. The most recent ZEW survey of institutional investors’ attitudes dipped into negative territory.  The IFO Business Climate Index has declined to its lowest level since June of 2010. These surveys clearly reflect the general deterioration in the global economic outlook.  Nevertheless, for the year 2011 as a whole, German GDP growth, which we estimate at 3%, will continue to be the strongest in the Eurozone and stronger than that of other advanced economies.

We are more troubled by the risks to the Eurozone and global markets posed by political developments in Germany.  It seems evident that to avoid a breakup of the euro, which would be extremely expensive for Germany and other creditor countries in the zone, the European Financial Stability Facility (EFSF) needs to be increased very substantially.  The clear message from bond markets is that such action is required. However, there is strong and growing resistance in Germany to any moves that involve stronger countries, in particular, Germany giving more financial support to weaker countries.  Friday, German Chancellor Angela Merkel proclaimed at a political rally that government leaders would not yield to “blackmail” by the markets on this issue.  She called for countries with serious debt problems to “do their homework and get their debt down.” The head of the Bundesbank (the German central bank), Jens Weidman, criticized moves in the direction of collectivization of unsound government budgets.  The German president, Christian Wulff, criticized as “legally questionable” the European Central Bank’s (ECB) recent purchases of the bonds of individual states in secondary markets.

Such comments are strongly influenced by the domestic political debate. Eventually, the government is likely to take whatever actions are needed to avoid financial disaster.  However, the government’s freedom of action could well become limited. The German Constitutional Court is scheduled to decide in September whether the EFSF and its proposed expansion in scope, as well as the bilateral loans for Greece, are consistent with the German constitution and EU treaties.  The German parliament, the Bundestag, will be voting on the EFSF in September.  Should the proposed expansion of the EFSF, agreed in July by the European summit, be blocked by Germany, the crisis will likely flair up dramatically, and the ECB may find it difficult to check the resulting contagion.

Global investors will continue to monitor developments closely in Germany and the Eurozone in the coming weeks.  The MSCI Germany equity market index has declined 22.45% so far in August (through August 26), considerably worse than the 13.11% decline in the MSCI advanced-country ex North America EAFE index and the 15.68% decline in the MSCI France index.  We are continuing to underweight the Eurozone markets in our International and Global Multi-Asset Class ETF portfolios.

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About Bill Witherell