Digging Into the German Economy – Market Disconnect

So here is the thing about Germany, whose flash purchasing managers’ indexes (PMIs) for October still registered overall contraction. Its economy remains in less than great shape. There are weak patches, and not just in its beleaguered manufacturing sector. But its economy isn’t its stock market—an often-forgotten principle that applies globally.

If you look on a purely headline basis, October’s PMIs seem like an improvement. Manufacturing ticked up from 40.6 to 42.6, a three-month high.^[i] Services also hit a three-month high, rising from 50.6 to 51.4, which—being over 50—indicates expansion.^[ii] But per S&P Global’s press release, new orders fell in both. By a smaller margin than in September, but a successive drop is not improvement even if the rate of decline eases. And while the decline was most acute in manufacturing—largely tied to the auto industry’s struggles—services businesses cited weak demand from their goods-producing customers. So there is some spillover.

All in all, this not-good report was in line with Germany’s longer-term trend of meh. And while PMIs reflect growth’s (or contraction’s) breadth rather than its magnitude, the latest are also in line with Germany’s nearly two-year stretch of up-and-down GDP.

And yet, German stocks are up nearly 17% year to date in euros and sit near days-old all-time highs.^[iii] How can the economy be so lackluster and stocks so hot?

We see a few reasons. One is markets’ efficiency. Germany’s problems, while real, are well-known, and expectations are low. When everyone sees a country as the proverbial Sick Man of Europe^TM, it doesn’t take much for reality to beat expectations.^[iv] Another reason is that the economy is only one market driver. Politics also affect stocks, and we think German markets benefit from gridlock there keeping legislative risk low. For all the talk about how Germany supposedly needs fresh industrial policy and public investment to get things cooking again, these things create winners and losers, which raises uncertainty and weighs on risk-taking and investment. Gridlock keeps this uncertainty at bay, enabling businesses to plan and invest with reasonable confidence that the rules won’t change on them.

But there is more. Germany’s economic composition doesn’t match its market make-up. Here, we aren’t even talking about sectors. We are talking about business type. The backbone of Germany’s economy is its famous Mittelstand—the legions of privately held and family-owned small and midsized firms. They are small factories, machine shops, designers, accountancies, hotels, you name it. There are also thousands of small local and regional banks serving them. They generate the largest share of GDP and collectively employ the majority of workers. The Mittelstand comprises much of the PMI surveys each month.

But the Mittelstand doesn’t factor in Germany’s main stock benchmarks (the DAX and MSCI Germany). These are the domain of much larger companies—companies with more global exposure and more economies of scale, making them better able to weather local economic headwinds. A flat local GDP stretch is going to mean less to an automaker, bank, chemical company, industrial equipment maker or clothing label with a global revenue stream than to a small firm whose clientele is overwhelmingly local. Domestic conditions still matter to big German firms, naturally, but global matters may offset or even matter more.

You can apply the same logic to any country. Ahead of next week’s Budget, remember UK stocks aren’t just the UK economy, tax system and politics. French stocks aren’t just the French economy, tax system and politics, either. The world is far too big and interconnected for that. Yes, local factors can have a big effect on sentiment at times. But over time, as stocks weigh fundamentals, they weigh how the entire world affects a company’s earnings outlook over the next 3 – 30 months.