The business cycle

Germany: Ouch! We got it wrong!

By September 26, 2017 April 25th, 2018 No Comments

Our predictions for the relative performance of the far-right AfD and the far-left Linke have been proved wrong! We expected Die Linke to surprise at 15%, while the party only achieved 9.2%; and AfD to “underperform” at 10%, while it reached 12.6%. Like those economic projections that turn out to be incorrect, we were left with a sour taste in the mouth. Alas, this is the price of experience.

Market concerns have accentuated about the future of Europe and the policy uncertainty ahead of the tedious coalition negotiations that are facing Chancellor Merkel. We believe that AfD’s performance was not strong enough to genuinely affect the outlook for Germany, or the Euroarea, but the wrong policy response to these results will indeed play in favour of the more extremist parties.

First and foremost, we think inflation is a growing problem for Germany and the rest of the Eurozone – the German elections do not change the tightening bias ahead for the ECB and a strengthening Euro outlook (we see the Euro-Dollar moving to 1.30 in the coming quarters). The easiest place to see this is in the chart below showing industrial pricing power expectations for Germany and in the Eurozone. The trend is remarkably similar, very clearly up and the level not that far off the levels reached in 2008.

Secondly, the strong performance of AfD signals a deep malaise among many German voters: true, but signals of a similar malaise about Europe and weak purchasing power have been visible and are still clear across most EU member states. As a result, in our view, the issue is how the EU should change to prevent this social malaise escalating in the future, rather than seriously discussing the likelihood of a hypothetical EU(ro) breakup in the next few years (the Brexit negotiations clearly show how hard this is, even when the will to leave is there).

In our view, there are three core topics that would see discussions and policy changes taking place; and one that would see discussions, but either no genuine progress or, de facto, limited progress.

There is a race to the bottom on corporate tax rates taking place: Hungary is currently leading with a 9% rate effective this year, with the majority of countries doing the same, and it appears to us that the new German government is likely to join in.

There is widespread social dissatisfaction with falling purchasing power for the majority of voters (those in the first three income quintile brackets at a minimum), a common concern about the perceived increased costs and falling investments in education and healthcare, as well as the effects on the labour market that advancements in digitalisation could bring. A simple response to this, in our view, would be the reallocation of the EU cohesion funds away from infrastructure-intensive projects to “productivity and quality of life” enhancement projects. Many fear that EU funds will dry up after the UK departs the EU – we beg to differ: they are likely to be readjusted and, in fact, even enlarged.

There is an increasingly stark difference between the balance sheet size – and, de facto, the market power – of small- and medium-sized companies and those of the uber-companies (those with annual profits that are now as large as the GDP of not-so-small countries: USD20-80bn a year). This trend  by now, in our view, has material implications for growth, employment and workers’ (i.e., voters) satisfaction. We believe that many changes could materialise in the coming years to partly address this disparity, ranging from taxation changes to regulatory amendments.

The one topic we expect to see widely debated, but not really solved, is a future close fiscal union at the EU level. On this issue, we see enormous political obstacles to anything that concentrates budget powers in Brussels beyond what is written already in the EU rules. We could see the creation of a figure at the EU level with budget responsibility, but this, in our view, would simply be a redefinition of what is in place already. The electorate in the EU is very clearly saying that it appreciates the EU project because of the peace it brought and because of its promise of prosperity for all. However, it fiercely dislikes the increasing bureaucracy it brings, and it forcefully resists the watering down of national identity – and policy freedom – that it has supported.