Germany’s weak economy has strong foundations

Happy Sunday, readers.

The German election is just two weeks away. The clouds have thickened over Europe’s largest economy. Surging energy costs following Russia’s invasion of Ukraine, rising competition from China and now the threat of US tariffs have sapped economic activity. Germany has registered negative growth for two straight years. The nation is sadly reclaiming its badge as “the sick man of Europe”.

That makes Germany the perfect candidate for Free Lunch on Sunday’s counter-consensus analysis. This week I researched the long-term optimistic case for the German economy. Here’s what I found.

First, reports of Germany’s industrial decline are exaggerated. German manufacturing is, in fact, surprisingly resilient and agile.

The energy crisis and supply chain disruption following the Covid-19 pandemic hit German industry. Energy-intensive industries such as chemicals and metals contracted. But, the IMF notes, other sectors adapted by “shifting into higher value-added products and using fewer intermediate inputs”. Electric vehicle exports rose 60 per cent in 2023. Electronic and optical production has picked up too, as has aircraft machinery.

The chart below shows that, although German manufacturing production has fallen, value added has remained steady.

Indeed, Germany’s long-standing expertise in engineering can be repurposed towards new growth sectors (at home and abroad). And though exports to the US and China may be affected by rising trade tensions, the nation remains the dominant industrial force in Europe.

Demand for defence equipment and green technologies is rising across the continent. Germany has a specialism in both, leading Europe for patents in green tech (and overall). It also ranks top among developed nations, well above the US and China, in the IMF’s index of comparative advantage in green goods. This includes in highly efficient power plants, intelligent grid design and charging technology.

Next, German industry’s vast strengths are underscored by the performance of its stock market. Despite the narrative of gloom around its economy, the Dax outperformed all other major indices — including the S&P 500 — last year.

The FT reported in December that the Dax’s strength was underpinned by Germany’s own Magnificent Seven: SAP, Siemens, Siemens Energy, Allianz, Deutsche Telekom, Rheinmetall and Munich Re. Their focus on global markets has insulated them from domestic economic weakness.

Though market concentration is a concern, these companies are spread across energy, telecoms and insurance — unlike the S&P 500, which as recent volatility has shown, is vulnerable to artificial intelligence-based corrections.

If these companies remain strong, there is an attractive buying opportunity for investors. Goldman Sachs notes that the overall German equity market trades at a historical discount to the US, even when adjusted for sector composition.

But German corporate strength extends beyond these large groups. Its industry is dominated by the Mittelstand. These small- and medium-sized private enterprises are unlike the smaller companies in the US and UK — they are more specialist and innovative, and are often branded “hidden champions”.

They include ZARM Technik (which makes devices that rotate satellites in space); Sick (a sensor manufacturer); KAEFER Isoliertechnik (which makes insulation technology); and König & Meyer (a musical stands maker).

The chart below shows that German industry is well-placed for value creation, being highly competitive in a number of growth sectors. (Researchers at BCG and the German Economic Institute developed a ranking methodology with sub-indicators for competitiveness and global market attractiveness, such as global market share, number of patents, market growth, intensity of competition and tech maturity.)

German industry generates significant revenues by selling goods and services abroad, which does expose it to shifts in demand and geopolitics.

But there are opportunities to sell more to Europe, especially in defence and green tech (particularly as trade wars intensify and the US pulls back from the renewables agenda). The domestic economic environment could also provide a headwind in the medium term.

The German election is an opportunity for a refresh. The likely next chancellor, Friedrich Merz, leader of the Christian Democratic Union, is expected to pursue some structural reforms. Coalition politics could dilute many of his plans, however.

Still, whatever the composition of Germany’s government, the glass half-full perspective is that even marginal improvements in policy could boost productivity growth (and support industrial agility).

First, the constitutionally enshrined “debt brake” — which requires the structural deficit to remain at 0.35 per cent of GDP — unnecessarily holds down public investment. The share of capital spending in Germany’s economy is one of the lowest in the OECD.

More than half of Germans support overhauling the borrowing limits. Indeed, the debt brake means the country has the fiscal room to raise spending on productive investments in its creaking road, rail and housing infrastructure.

With public investment so low, even a slight loosening of the debt brake would make a notable difference (estimates suggest Germany could also borrow an additional €48bn a year, or about 1.2 per cent of GDP, without conflicting with EU fiscal rules).

There’s more low-hanging fruit. Recent permitting reforms have fuelled a rapid buildout in renewables, underscoring the high returns to slashing bureaucracy. Indeed, it takes 120 days to obtain a business licence (more than double the OECD average), according to the IMF. Government digitalisation is also behind. For instance, just 43 per cent of services pre-fill personal data on online forms compared with the EU average of 68 per cent.

There are political hurdles to overcome to raise investment and ease the time and cost burden of red tape. Productivity gains will take time. But even incremental improvements on a low base would be growth-enhancing.

One sticking point is immigration. The working-age population is shrinking fast, and Germany suffers from a number of skill shortages. If migration remains politically fraught, reskilling initiatives will need more investment. The country is, however, making strides in robotics, which can help free workers for higher value-added employment.

Germany’s recent economic performance has been undeniably depressing. It is unlikely to turn around soon. But the narrative of its industrial decline is overblown. Downbeat headlines are concealing the nation’s underlying strengths in manufacturing and innovation.

Germany AG (and GmbH) has the expertise to pivot into growing sectors, including in green tech, defence and advanced manufacturing. The political class has also woken up to the dependencies of the old economic model. This gives hope that, in time, Germany could ride the wave of creative destruction, particularly if policymakers can play an enabling role.

Thoughts? Rebuttals? Message me at [email protected] or on X @tejparikh90.

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