German Locomotive Losing Steam

Recent economic news from Germany, which has the largest economy in Europe and is considered the “locomotive” for the Eurozone, has not been good. Factory orders in June declined 3.3% from the May level and 2.4% from a year earlier. This followed a 1.6% drop in May. The Purchasing Managers’ Index for manufacturing has been flat for three months. Industrial production registered an advance of only 0.3% over the May rate, following declines in the previous three months. Retail sales and car sales were weak in April and May. The German 10-year Bund yield has declined to a record low yield of 1.06%.

German GDP growth probably ground to a halt in the second quarter – and may have actually declined – following a quarterly gain of 0.8% in the first quarter. While some pickup is likely in the coming months, growth in 2014 is likely to fall below the previously expected 2.0%. In the medium term, growth should ease to the rate corresponding to full employment, about +1.5% per annum due to a declining labor force. Nevertheless, the German economy will likely grow faster than its Eurozone neighbors. Eurozone growth this year is likely to be only about 1.1%.

The tensions between Ukraine and Russia have affected business confidence, with the latest round of sanctions and countersanctions adding to the perceived risks for trade. All Europe has been affected by these tensions, as well as by the stalling of the German economy. The Italian economy, for example, now appears to be slipping into recession. The French economy also has failed to establish sustainable growth. While the Spanish economy is seen as having been transformed by its structural reforms, industrial production in Spain fell by 0.8% month-to-month in June, following a 0.6% drop in May. The euro has slipped to a nine-month low.

German equities have underperformed this year. The iShares MSCI Germany ETF, EWG, declined 9.82% over the past four weeks and is down 11.8% year-to-date, substantially below the year-to-date 7.47% decline in the iShares MSCI EMU ETF, EZU, which covers all the equity markets in the European Monetary Union. In our International and Global portfolios we decided in July to close our Germany-specific positions, which we had held since January of 2012.

The fundamental and technical factors for German equities do not appear attractive now in comparison with some other markets. In Europe, the UK economy continues to outperform, with growth this year likely to be better than 3%, higher than that of any other G7 country. We also have positions in the equity markets of Spain, Norway, and Belgium.

One factor negatively affecting US dollar returns from equity markets in the Eurozone has been a decline in euro–US$ exchange rate. It is now at a nine-month low. We are maintaining a position in the WisdomTree Europe Hedged Equity Fund ETF, HEDJ. It includes a hedge against changes in the euro–US$ rate. It also favors European firms paying higher dividends. This ETF is down only 2.78% year-to-date, far less than the 7.47% decline for the EZU Eurozone ETF cited above.

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