Europe’s ‘Sick Man’ Is Healthier Than Expected

Here are some not-so-random numbers: -0.1%; 4; -0.2%; -4.1%; 53.7%. These figures are, respectively, Germany’s Q2 2024 quarter-over-quarter GDP growth rate; the number of times German GDP has declined in the past seven quarters; consumer spending’s Q2 growth rate; business investment in machinery’s Q2 growth rate; and German stocks’ total return, in euros, since 30 September 2022, the last day before GDP’s up-and-down streak started.^[i] In our view, this underscores a very simple point about how markets work, one we think is lost in the constant warnings we have seen over Europe’s weak economic link.

Germany’s economy appears to be in a rough patch, and we think Tuesday’s revised Q2 GDP report puts more colour to this by revealing the breakdown. GDP has flipped between contraction and growth since Q4 2022.^[ii] Exports are down since February 2023, with China a primary source of weakness.^[iii] Household spending is down, cumulatively, since Q3 2022.^[iv] Business investment has chopped sideways since then.^[v] And through it all, commentators we follow have warned of high energy costs, struggles in Germany’s mighty auto industry and the mittelstand of midsized manufacturing firms, and a weak public purse that can’t do anything about it. (Oddly, we didn’t see much praise for public spending’s 1.0% q/q rise.)^[vi]

And yet, German stocks are up over 50% in euros since the trouble began.^[vii] When we match currencies, they are outperforming America’s S&P 500 index and global stocks.^[viii] Yes, troubled Germany, widely called the proverbial Sick Man of Europe by commentators we follow, is beating the world.

How?

Well, in addition to being the end of Germany’s GDP growth streak, 30 September 2022 marks the first trading day after German stocks hit their local-currency low during 2022’s global stock market downturn (which hit bear market territory in US dollars).^[ix] Based on our research, that downturn fell on a host of widely perceived negatives, including spiking energy costs in the aftermath of Russia’s invasion of Ukraine and acute energy shortages in Europe.^[x] Headlines we follow said these would hit Germany particularly hard, hammering its factories and chemical plants. Weak demand in China, which was still dealing with COVID restrictions, would allegedly put the final nail in the coffin. At the time, analysts and headlines we follow projected a deep recession (period of contracting economic output).

We think stocks, which our research finds are efficient and forward-looking, priced these expectations as they emerged, well before September 2022.^[xi] In our view, they dealt with widespread calls for recession and fell hard.^[xii] But then, seemingly having priced the potential economic fallout of Germany’s headwinds, they bounced with global markets.^[xiii] Even as German GDP wobbled sideways, even as exports continued sliding, even as manufacturing purchasing mangers’ indexes (PMIs, monthly surveys that track the breadth of economic activity) deepened further into contraction, stocks rose.^[xiv]

We think this is partly because global trends tend to swamp local … and partly because, poor as some of Germany’s economic data were and are, this wobbly sideways bounce isn’t the deep recession we saw so many economists and headlines call for. In our view, whether something is objectively good or bad isn’t the sole consideration or even the most important one for stock market returns. Rather, our research finds stocks move on the gap between reality and expectations, which we think is key here. When expectations are as low as they have been toward Germany’s economy, we find the actual outcome needn’t be grand. Not even good, not even just ok. To achieve the positive surprise our research finds necessary to boost stocks, simply not as bad as feared seems to have sufficed. When everyone foresees calamity, mild negatives can be good enough for stocks, in our view.

But this is all in the past, and we find stocks look forward. We think investors benefit from doing so, too, assessing where expectations are and how likely reality is to beat them. To us, the gap still looks wide. Based on sentiment surveys like Monday’s Ifo survey—which showed expectations and the current assessment toward Germany’s economy falling again in August—and the general tenor of headlines we follow, expectations seemingly remain quite low.^[xv] But these surveys and headlines cite the same long-running headwinds, namely, factory weakness, energy costs and China.

What appears to be receiving less notice: Germany’s services sector, which is bigger and more economically important than manufacturing and which isn’t in universally bad shape.^[xvi] PMIs show the majority of the sector is growing.^[xvii] Germany’s Federal Statistical Agency doesn’t aggregate services as a broad sector, but five of the seven services categories expanded in Q2, including information and communication (0.6% q/q), business services (0.9%) and financial services and insurance (0.2%).^[xviii] The forward-looking new business component of S&P Global’s Services PMI remains in expansion.^[xix] With wages continuing to grow and restore households’ lost purchasing power, we think there is a high likelihood the unheralded services sector, the seemingly unseen bulwark of Germany’s economy, keeps growing.^[xx]

This may not launch a sustained GDP growth streak. Again, conditions in Germany appear mixed. But in our view, overlooked services growth should be enough to keep the worst-case projections from coming true, and a Germany that keeps muddling along would likely be enough of a positive surprise.