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 September 30, 2022, the last day before GDP’s up-and-down streak started.^[i] This underscores a very simple point about how markets work, one lost in the constant handwringing over Europe’s weak economic link.

Germany’s economy is clearly in a rough patch, and Tuesday’s revised Q2 GDP report puts more color to this by revealing the breakdown. GDP has flipped between contraction and growth since Q4 2022. Exports are down since February 2023, with China a primary source of weakness. Household spending is down, cumulatively, since Q3 2022. Business investment has chopped sideways since then. And through it all, tales of high energy costs, struggles in Germany’s mighty auto industry and the “mittelstand” of midsized manufacturing firms, and an anemic public purse that can’t do anything about it. (Oddly, public spending’s 1.0% q/q rise didn’t cheer many onlookers.)^[ii]

And yet, German stocks are up over 50% in euros since the trouble began. When we match currencies, they are outperforming the S&P 500 and global stocks.^[iii] Yes, troubled Germany, the proverbial Sick Man of Europe^TM, is beating the world.^[iv]

So what gives?

Well, in addition to being the end of Germany’s GDP growth streak, September 30, 2022 marks the first trading day after German stocks hit their local-currency low during 2022’s global bear market. That bear market fell on a host of fears, including spiking energy costs in the aftermath of Russia’s invasion of Ukraine and acute energy shortages in Europe. Headlines 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. Investors and most forecasters projected a deep recession.

Stocks, efficient and forward-looking, priced these expectations as they emerged, well before September 2022. They dealt with recession fears and forecasts and, as one would surmise, fell hard. But then, seemingly having priced the potential economic fallout of Germany’s headwinds, they bounced with global markets. Even as German GDP wobbled sideways, even as exports continued sliding, even as manufacturing purchasing mangers’ indexes deepened further into contraction, stocks rose.

We think this is partly because global trends swamp local … and partly because, bad as some of Germany’s economic data were and are, this wobbly sideways bounce isn’t the deep recession so many economists and pundits expected. Whether something is objectively good or bad isn’t the sole consideration or even the most important one. It is critical to remember stocks move on the gap between reality and expectations. When expectations are as low as they have been toward Germany’s economy, the actual outcome needn’t be grand. Not even good, not even just ok. To achieve the positive surprise necessary to boost stocks, simply not as bad as feared seems to have sufficed. When everyone expects calamity, mild negatives can be good enough for stocks.

But this is all in the past, and stocks look forward. So investors should, too, and assess 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, expectations remain quite low. But these surveys and headlines cite the same long-running headwinds, namely, factory weakness, energy costs and China.

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

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