Equity investors take note: Germany’s economy is on the mend

by Levi Folk | April 23, 2007

Germany, long the sick man of Europe , is on the mend. Improved competitiveness is boosting exports and the economy while labour market reformation is spurring employment. The net result is higher corporate profitability, stable inflation and improving fiscal balances. Equity investors take note.

Rigid labour markets are long the Achilles heel of Europe. High taxation of labour and generous unemployment benefits have been the primary causes of structural unemployment in Europe, and Germany has not been immune to this form of Eurosclerosis.

There are role models in Europe, those who have endured painful labour market reform and invigorated their economies as a result, Ireland being the example that comes to mind. Ireland successfully reduced unemployment by 12 percentage points over the decade beginning 1995 by cutting taxes on labour in exchange for wage moderation by unions.

Germany’s economy has undergone a painful period of labour restructuring that has seen rising unemployment and falling real wages until quite recently as companies shed labour to cut costs and outsourced production to emerging economies. Unemployment shot up to a high of 12 percent in 2005 as labour costs were squeezed. Labour cost increases in Germany were the lowest in Europe in 2005 aided in part by falling non-wage costs.

The government concurrently put policies in place to reduce structural unemployment. A much stricter means-tested approach to entitlement has been put in place to reduce payouts to the unemployed, and “reasonable offers” of employment can only be refused by penalty.

Corporate cost cutting has allowed German corporations to regain competitiveness. Unit labour costs actually fell by almost 10 percent from 2003 to 2005. These gains in competitiveness have allowed German companies to compete globally under the strains of a rising currency, the Euro, which has appreciated by 35 percent versus the US dollar since 2003.

For all the Euro’s strength, German exports have been booming, which is no small matter. The trade surplus has carried the economy while the consumer has retrenched due to job insecurity and stagnant wages. In 2005, 9 million jobs were derived from the export sector and generated 40 percent of GDP according to the Financial Times.

A major overlooked factor is the level of sales coming from companies’ foreign subsidiaries—a level that exceeds the total value of the country’s exports. Companies comprising the Dax-30 stock index made three quarters of their turnover abroad in 2005 and that number is probably higher today. The global economic boom driven by the industrialization of China has been very good to Germany .

All told, the economy rose 2.5 percent in 2006 and is expected to do the same in 2007 which may seem low by North American standards but is remarkable for an economy that has been limping along since 2000.

Business confidence is buoyant at roughly a 15 year high, and th e confluence of higher wage gains and rising employment is likely to boost consumer spending over the next year. Domestic jobs are finally rising, by a million over the past year, and the unemployment rate is finally receding, from a high of 12 percent in 2005 to a rate of 7.5 percent today.

Expectations are that the dormant domestic consumer will emerge from the woodwork and add balance to Germany ’s economy. A recent union-brokered 4.3 percent wage gain in the chemical industry is a sign that the pendulum is swinging back to labour after years of allowing corporate output to flow to profits.

Profitability may take a knock from wage gains, but interest rates are low by global standards and remain accommodative of growth. The European Central Bank (ECB) has been patient with interest rate normalization because growth in the EU has been weak and inflation has remained contained at a hair under 2 percent.

Expectations are that rates, currently sitting at 3.75 percent, will continue to be notched up slowly by the ECB, to keep a lid on inflation as economic growth is starting to accelerate.

Whatever the case, rates are accommodative for the time being and supportive of the merger and acquisition (M&A) wave that is sweeping across Europe . Cash yields on public companies in excess of borrowing costs will continue to drive M&A activity and stock market gains.

The opportunity to invest in Germany remains because the market is still cheap. Equity market valuations have been trending down since 2000 despite the substantial rise in index values since 2003.

The iShares Germany Index Fund (EWG) which tracks the MSCI Germany Index has roughly tripled in value (US$) over the past three years. Yet, the P/E ratio, at 13 time earnings, is below the long-term average of 15 and looks compelling on a historical basis dating back to 1989. The fact of the matter is profits have been growing faster than prices.

The country is on a positive trajectory that is supported by global growth. The one time sick man of Europe is on the mend, so equity investors should take note.