Impossible Germany

Pieter_Bruegel_d._Ä._037My Comments: I’ve mentioned before how easy it is for us to discount the economic influence of Europe on the world stage. But it’s a mistake to do so. Collectively, the European Union is an economic engine that is just as critical to the economic welfare of the world as we are. If they go down the tubes, so do we, just not so far. But down is down and not a fun place to be.

One reason Europe has been reluctant to respond aggressively to what Russia has been doing to Ukraine and it’s environs is because Germany, and much of the rest of Europe, know they are already walking on thin ice. Shutting out Russia means pissing in your own well, to borrow a phrase.

And, of course, Russia is happy to push those buttons as long as they can get away with it. What makes it troubling for me is that it might simply be delaying the inevitable. And I for one don’t want that inevitable to be known 25 years from now, as World War III.

Nov. 16, 2014 Eric Parnell, CFA

Summary
• The economic and market outlook appears impossible for Germany over the next few years.
• The world’s fourth-largest, heavily export-dependent economy is facing a fundamental problem.
• With future growth prospects increasingly fading, this bodes ill for the future performance of the German equity market.

The economic and market outlook appears impossible for Germany over the next few years. The world’s fourth-largest, heavily export dependent economy is facing the fundamental problem of struggling to thrive within the currency union it went to such lengths to help form over the last several decades. Future growth prospects are increasingly fading, and this bodes ill for the future performance of the German equity market.

German economic growth has effectively ground to a halt in recent years. After what was initially a fairly solid bounce in the early years of the “post-crisis” period, real GDP growth in Germany slowed to +0.7% in 2012 and +0.4% in 2013.

As for 2014, German real GDP growth projections for the year were recently revised meaningfully lower from 1.9% to 1.2%. More specifically, the economy just barely skirted past entering a technical recession by generating +0.1% growth in the third quarter, after having posted a negative -0.3% growth reading in the second quarter. It is worth noting that Germany managed to clear the bar into positive territory thanks to a surprisingly solid export number to non-Euro trading partners in September, a outcome that may not prove repeatable in future months. And despite the fact that Germany just barely avoided officially having the dreaded “R” word tied to their economy, these are still hardly growth numbers about which to get excited.

As for 2015, the growth projections have already been reduced to just 1.0%. And experience in the post-crisis world has repeatedly shown us that future economic and corporate earnings growth projections are simply made today to be lowered in the future. As a result, a final number for 2015 that is closer to 0%, if not outright negative, should not be completely ruled out.

Economic growth is grinding to a halt in Germany. But so what? Economic growth has been sluggish in the United States for years, yet the stock markets in both countries are now well above their pre-crisis highs. Can’t we simply expect the same degree of perpetually blind optimism among German stock investors to bid their own stocks to the stratosphere as well, fundamentals be damned? After all, it has worked well so far, as both the U.S. S&P 500 Index (NYSEARCA:SPY) and the German DAX have moved in virtual lockstep with each other in local currency terms dating back to the very beginning of the financial crisis in July 2007. That is, of course, until this past July, when these markets suddenly started to diverge widely from one another.

It is worth noting that currency effects have amplified the return differences between the U.S. and Germany since the summer of 2011. This is due to two specific periods – the first from the summer of 2011 to the summer of 2012, and the second since April 2014 – where the euro currency weakened sharply relative to the U.S. dollar. Thus, for those investors that have not hedged the currency, exposures associated with their German stock investments through vehicles such as the iShares MSCI Germany ETF (NYSEARCA:EWG) have not performed nearly as well.

But what about a monetary policy rescue in Germany and across the eurozone? Unfortunately for stock investors in the region, Germany does not claim to want such stimulus, and even if the European Central Bank decided that it wanted to provide it, they, unlike their American and Japanese counterparts, do not have a central bank that has the unchecked power to decide to print a few trillion euros out of thin air simply because their central bank head thinks that it is a good idea over his cereal one morning. Instead, ECB President Mario Draghi faces far more restrictions on his ability to engage in outright quantitative easing, and that includes getting clearance from German policymakers that have stated they do not want it.

What has been absolutely extraordinary to this point is how Mr. Draghi has been able to repeatedly boost regional stock and bond markets including Germany for years by doing nothing more than making promises about things he intends to do (and may not technically be able to do), without actually doing much of anything. How much longer his power of the podium can sustain itself remains to be seen, but the recent performance of stocks across the region suggest that equity investors both in Germany and elsewhere may be growing increasingly tired at this stage, particularly now that the spillover tailwind from the Fed’s quantitative easing has finally gone away.

Looking forward, the German stock market faces a fundamental problem that investors would be well served to confront sooner rather than later. In short, the German economy has experienced real growth of only 3% above pre-crisis levels from late 2007 and early 2008. Yet, the German DAX is nearly 20% above pre-crisis levels. More specifically, the German economy has posted a real GDP increase of just 1.4% since the summer of 2012, yet the DAX is up nearly 50% over this same time period. Put more simply, German stocks have skyrocketed over the last two years based on virtually nothing fundamental. Such are not the strong foundations of sustainable stock market gains into the future.

Adding to the forward-looking challenges for German stocks is the highly cyclical and economically sensitive make-up of the market. German stocks are more heavily concentrated in the variety of cyclical industries, including consumer discretionary, financials, industrials and materials. Overall, the allocation of the German stock market to cyclical industries is a notably high 82%. This is well above the U.S. reading at just over 70%. As a result, the German stock market is expected face more pronounced downside pressure if economic conditions in Germany deteriorate as we move into 2015.

Yet another issue for German stocks is valuation. For example, Germany’s 10-year cyclically adjusted price-to-earnings ratio is 16.4. While this reading is not the extraordinarily high 26.6 reading currently hanging over the United States, it is still a fairly lofty number in its own right. Moreover, Germany’s trailing 12-month price-to-earnings ratio is a notable 17.1, which is fairly reasonable but not necessarily what would be considered cheap. As a result, German stock investors should not expect to find comfort and support in deeply discounted valuations, as we are far from such an outcome at this point.

For those possibly interested in exploring individual German stock themes as an alternative to a broader exchange traded fund, it is worth noting they will find a limited selection of stocks from which to choose. At present, only six companies that are domiciled in Germany trade on the U.S. exchanges. And only three – SAP (NYSE:SAP), Deutsche Bank (NYSE:DB) and Fresenius Medical Care (NYSE:FMS) – are of any meaningful size from a market capitalization standpoint. Other larger names such as Siemens (OTCPK:SIEGY) and BASF (OTCQX:BASFY) that once traded in the U.S. have since departed from the American exchanges back to Germany.

For reasons discussed here and more, owning German stocks is less than desirable at the present time even after the recent pullback, given the persistent potential downside risks. And while U.S. may not be listening, what is unfolding in Europe along with many other global stock markets is important, for it is foreshadowing what is likely to arrive on U.S. market shores someday. For while U.S. stock investors can continue to ride off of “the best house on a bad block” theme, if conditions on the block continue to deteriorate, it is only a matter of time before the spillover effects begin to adversely and directly drag down this remaining “best house”.

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