Receive free market insight updates
we will send you myFT Daily Digest Email summary of latest news market insights There is news every morning.
The author is Chief Investment Officer of Pictet Wealth Management Company
Germany has the tools to boost its struggling economy, but will it use it? Berlin’s fiscal strength gives it an option to revive growth that most other countries can only dream of: a deficit-financed investment program.
This choice will allow Germany to abandon its obsession with a “black zero” balanced budget and instead invest in a red budget to fund fiscal stimulus plans to restructure the economy. Yet Berlin is so debt-averse that it not only refuses to take the deficit pill but actually seeks to tighten fiscal restraint – even as the economy risks slipping into recession for the second time in a year.
After easing the country’s fiscal policy during the pandemic, German policymakers are returning to normalcy. They are also acutely aware that “bond vigilantes” appear to be back, ready to impose discipline on policymakers and force them to rein in inflation expectations by raising government bond yields.
What impact will this have on investors? The re-emergence of bond vigilantes suggests central banks can keep interest rates higher “for longer” to combat rising structural inflation, driven by tight labor markets and increased demand for materials and investment needed for the energy transition Structural inflation.
Against this backdrop, yields on U.S. and euro zone investment-grade corporate bonds with maturities up to five years are attractive and should remain attractive as long as inflation is under control and the coming recession is mild. It’s worth noting that any prospect of the ECB bailing out Germany is far-fetched. Just as Berlin prioritized fiscal discipline over growth, the ECB prioritizes price stability. We don’t expect the ECB to cut interest rates until at least the second half of 2024.
The “reshoring” trend has exacerbated structural inflation, which is a direct result of intensified strategic competition. This trend will put pressure on an already tight labor market. The increasingly fraught geopolitical environment is also beginning to overshadow the importance of central banks to the global economy. In short, we are moving from an era of currency dominance to an era of geopolitics dominance.
This new normal challenges the German model of multilateralism. Roughly speaking, Germany has for decades relied on cheap Russian gas to produce goods for export to China, while enjoying the security of the U.S. defense shield. Now that Russian gas is gone, China has become the world’s largest car exporter, and Berlin has had to increase military spending to bolster national security after Russia invaded Ukraine.
To be fair, Germany’s current situation is no longer what it was in the 1990s. After reunification, Germany was called the “sick man of Europe.” But the competitiveness Germany won through reforms in the early 2000s is now waning, and changes in global economic dynamics on which Germany’s export growth engine depends have exposed structural problems.
Indeed, ten years after the eurozone crisis, the relative positions of the southern eurozone countries and Germany have reversed. Greece is currently leading the euro zone’s southern economies in a strong post-pandemic recovery. We expect Germany’s gross domestic product to shrink by 0.3% this year, while the euro area as a whole is expected to grow by 0.5%.
Germany has room to take action: German public investment accounts for 2.7% of GDP, behind the United States’ 3.4%. However, Germany is planning to cut spending and stick to its debt brake rules, which are suspended from 2020 to 2022 to help cope with costs related to the Covid-19 pandemic.
There is no political consensus in Berlin to repeal the rule, which was enshrined in the constitution in 2009 to limit the central government’s structural budget deficit to 0.35% of GDP. While there may be some “off-balance sheet” fringe creativity, such as Germany’s €100 billion special fund for military spending, Berlin wants to keep debt issuance tight, in line with national instincts left over from the hyperinflation of the 1920s.
The Bundesbank urges German companies to reduce investment in China. Corporate-level efforts to increase production capacity as part of reshoring will mean an increase in capital spending, from which companies in many industrial sectors should benefit. It is still possible that German companies will be part of this restructuring effort, but without fiscal stimulus, the structural problems facing the country’s economy will make restructuring more difficult.
Svlook
