Will Germany slow down next year?

Many emerging market (EM) economies rely on Eurozone growth for their exports, foreign aid and investment, and 30% of this growth is driven by Germany. Multinational firms therefore should be closely monitoring the economic and political risks the country is facing, given its critical importance within Europe as well as the world.

Fortunately, despite alarmist headlines and warnings of weaker trade, the German economy is robust and will continue to grow by 1.7% year-on-year (YOY) next year thanks to strong domestic demand. Growth accelerated in Q2 2016 – driven by a 2% YOY rise in consumer spending in H1 – and will rise further in Q3. Meanwhile, government spending grew at its fastest pace since 2010 in Q2, driven by additional spending on infrastructure to accommodate 1.5 million immigrants.

Germany consumer confidence

Beneficial conditions in employment, inflation, and credit in the past years, supported by a solid export sector, are driving this upward trend in consumer spending. Unemployment is around 4%, its lowest level since reunification in 1990, and the implementation of labor reforms in the mid 2000’s has resulted in a 10% increase in wages since 2007, enhancing labor productivity yet maintaining economic competitiveness. A muted price outlook driven by a drop in energy costs has further increased the purchasing power of German consumers. Strong credit, facilitated by low European Central Bank (ECB) interest rates, and more housing for immigrants has prompted a construction boom while bolstering overall confidence in the economy.

Still, the German economy isn’t expected to accelerate, as challenges in the banking and export sector along with domestic political risks hold back economic potential. Germans have placed 40% of their financial assets in German banks, and the negative deposit rate by the ECB suppresses their investment and retirement prospects. Additionally, the record-low interest rates limit the profitability of the banking sector, which is still struggling to recover from the 2008/2009 financial crisis. For instance, Deutsche bank has been undercapitalized since the financial crisis and still has €55 trillion of systemic global exposure in derivatives. Despite the threat of a US$14 billion fine by the United States (US) Department of Justice due to the mis-selling of mortgage-backed securities, the bank is expected to succeed in paying a much smaller fine, while consolidating global operations and cutting only 3,000 jobs in Germany to improve viability.

German banks

On the external side, the stronger euro has limited exports from growing more strongly this year, particularly as demand from Germany’s main trading partners (US, China and the rest of the EU) has been weaker and more volatile compared to earlier years. Vehicle exports and machinery – amounting to nearly 40% of total exports – have been highly volatile though still on a growth trend, rising by 2% YOY through August. Likewise, industrial and manufacturing production are growing minimally, and factory orders will remain stagnant this year.

A weaker euro in 2017 will lead to a rise in German exports, which will gain steam starting in Q1. Although Brexit and the ECB’s Quantitative Easing have failed to depreciate the currency in 2016, the euro will eventually weaken next year in the light of a combination of pressures and risk factors. An anticipated US interest rate hike in December, followed by subsequent hikes as well as various European political risks across 2017 – the French presidential elections, start of Brexit negotiations, and the German federal elections – will ensure the euro falls against the dollar.

Euro strength

Starting from the end of 2017, slow global demand, fewer industrial investments and fiercer international competition will start to negatively weigh on the manufacturing sector that currently contributes 23% to German economic growth. During this long-term transition where domestic demand will propel economic growth, the automotive sector will remain the industrial backbone of the economy. In this weak external demand environment, multinational firms will be required to adjust their strategy, as B2B customers will become more demanding and price sensitive.

On the political side, domestic tensions have risen over the influx of migrants in the past couple of years. Half of German voters are disappointed with Chancellor Merkel’s welcoming immigration policy, asking for a migration cap and the deportation of immigrants. Rising frustration and hostility between migrants and locals has led to the growth of the Alternative for Germany (Afd) anti-immigration far-right party, which has seen some local election victories in recent months.

High immigration

Matched with the Christian Democratic Union of Germany (CDU)’s weak performance over the past year, Chancellor Merkel is facing a major challenge to re-election. She is expected to run again with the support of the CDU and sister party Christian Social Union in Bavaria (CSU) in the German federal elections in the autumn of 2017 and a grand coalition similar to the current one will likely arise between the CDU, CSU and the Social Democratic Party of Germany (SDP). The latest polls indicate that the CDU/CSU will secure 30% of the vote (from 41.5% in the previous elections) and SDP 22% (from 25.7% previously), barely achieving the majority required to pass legislation. However, a weaker coalition will make the government more unstable with a stronger opposition, potentially requiring further collaboration from the Greens or the Left. Expansionary fiscal policies that could accelerate critical social spending and investments, and boost economic growth are highly unlikely in this scenario, also contributing to softer growth from end of 2017.

Multinational firms should focus on continued opportunities in the consumer sector, and segment their market within the resilient industries to mitigate the business risks from the economic and political challenges that the country will face next year.

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