What has happened?
Financial markets have begun the New Year on a stronger footing, but European macro data continues to disappoint. Purchasing Manager Indices in most European countries as well as the Eurozone’s economic sentiment indicator have remained on a downward trajectory. Especially, the German industrial production print – released earlier this week – has stoked fears that Europe’s biggest economy is on the brink of a technical recession. Indeed, the 1.9% monthly contraction in November was not only much worse than consensus expectations of a 0.3% expansion, but means that industrial production has probably declined in the last quarter of 2018. In fact, if industrial output is unchanged in December – which is not unlikely given the holiday season –the fourth quarter reading might reveal a similar industrial production drop as in the previous quarter (of around -1.7%). Two consecutive quarters with negative industrial production growth could translate into two negative quarters of GDP growth which would mean a technical recession. Admittedly, the importance of industrial production for the German economy has decreased significantly over the past few decades and problems with the auto sector have also impacted recent output levels. The industrial sector accounts for less than one third of the German GDP. This also means that a drop in industrial output does not inevitably lead to a recession. However, the industrial sector tends to be very sensitive to business cycle swings and, as a result, bigger changes in its output have been a good forecaster of economic turning points.
What would a German recession mean?
A negative fourth quarter GDP reading would mean that Germany has entered a technical recession. A technical recession is defined simply as two consecutive quarters with GDP contraction, and there was a -0.2% drop in GDP in the third quarter. The psychological effect that any recession headlines would have on risky assets, but also consumer and business sentiment should not be underestimated. After all, Germany is not only Europe’s biggest economy, but also has been one of the most reliable European growth engines in recent years.
However, a technical recession would not change the fact that Germany’s economy remains in robust shape. While the requirements for a technical recession might have been met, the definition of an economic recession in a broader sense doesn’t really seem applicable. The most widely accepted definition for an economic recession comes from the U.S. National Bureau of Economic Research (NBER): “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." German real income, employment and wholesale & retail sales all remain ingood shape. The disappointing industrial production is mostly caused by temporary supply-side issues, namely, the production shortfalls in the automotive industry related to emission test delays and also drought-related problems, for example in the chemical industry. Capacity utilization is still high in historical terms, suggesting an economy that is still prospering.
Financial markets have shown little interest in the threat of a technical recession in Germany. The German DAX index has rallied by 3.2% year-to-date. 10Y German government bund yields have barely moved. We see two reasons for this divergence between financial markets and macro data. First of all, a lot of bad news has been priced in after the December sell-off. Secondly, bad European and German macro news has been pushed into the background by more market-friendly headlines in the U.S. (labor market report, Fed comments) and Asia (Chinese RRR cuts).
Taking all leading and coincidence indicators into account, we think it is still likely that German growth was positive in Q4 and therefore a technical recession will be avoided. Private and public consumption still have the potential to offset the industrial downturn. For example, German retail sales were encouraging in the first two months of Q4 (0.1% and 1.4% mom growth).
However, the risks of a technical recession have increased in recent months and can definitely not be neglected. The title of our annual outlook publication is “Beyond the peaks” and we may well be past peak GDP growth and a slowdown was to be expected. Robust consumption growth amidst a strong labor market will help guard against a technical recession in Germany or Europe more broadly, but fears around it could weigh on financial markets as well as on European business and consumer sentiment. This in combination with lingering global uncertainties could reinforce the growth deceleration. We expect Eurozone growth to slow to 1.6% in 2019 from 1.9% in 2018. With regard to the investment outlook, we would like to reiterate some of our 2019 outlook themes: expect slower macro and corporate earnings growth, be vigilant on volatility and prefer U.S. over European equities.
Download this CIO Insights Memo as a pdf here.