Can Germany’s Economy Recover? | The Big Conversation | Refinitiv
ROGER HIRST: Germany's DAX index is testing its all time highs, which is quite remarkable given the weakness in Chinese demand and the collapse in global auto sales. So is the German equity market bullet proof? That's the big conversation. The German equity market has defied the macro data, and the macro data is far from reassuring. Last week's German industrial production data saw an unexpectedly large decline in the headline figure. And this data was for the month of December, well before the Corona virus outbreak had started to impact global supply chains. The month on month number for industrial production declined 3.5% versus expectations of a -0.2% fall, whilst the year on year number fell 6.8% versus a forecast of a fall of 3.7%. Both numbers were the lowest levels we've seen since the great financial crisis of 2008 to 2009. And these data points were taken before that impact of coronavirus would have worked their way into the numbers. So therefore, the outlook for Germany remains incredibly shaky. A rebound in European PMIs and in particular, some of the forward looking indicators, such as new orders had raised hopes that the worst of the global slowdown was in the rear-view mirror and the progress on the US China trade dispute would help German manufacturing recover. However, although the January German Markit manufacturing PMI has rebounded off its lows, it remains in contraction territory, having languished in that sort of sub 50 area for over a year. December exports, imports and factory orders also fell well short of expectations, with factory orders in particular falling deeper into negative territory. At the heart of the issue has been the well-documented decline in global auto sales. The 12 month moving average of German new car production has declined at a rate that is spectacular, even when compared to the collapse in output during the great financial crash. While structural changes in the demand and usage of cars are obvious headwinds, changes in emission policy in both China and Germany were supposed to be one off hits that would now dissipate. China and Germany accounted for about 19 percent and 14 percent respectively of BMW sales and Brexit Britain accounts for a significant portion of the 32 percent sales that goes to the rest of Europe, where the outlook is also very uncertain. Volkswagen has roughly the same exposure to these regions, whilst Daimler’s exposure to China is lower at 12 percent, with the US making up about a quarter of sales and revenue. Germany is not, however, a one trick pony based on automobiles, although heavy industry does play a very significant part in the overall economy, where exports are the engine driving GDP. The headline German Equity Index, the DAX 30 is about 43 percent heavy manufacturing. If we lumped together chemicals, autos and the industrial sectors and the balance is made up of primarily software, financial services and healthcare - though within this sector buyer does have a significant chemicals presence too. The economy, also has sizeable non listed sectors with many high quality industrial companies such as Bosch being held in private or family hands. Nonetheless, Germany remains very vulnerable to developments in the global economy. China's main imports are commodities and high end manufactured goods, of which German products are a major component. The DAX itself has long been used as a proxy for global growth and even a developed market play on the emerging market growth story. Considering the magnitude of the lockdown in China's industrial heartland and the uncertainty about the length of this outage, which could persist for another month, maybe more, it's surprising in some ways that the DAX is currently testing its all time highs. And the big question is whether the makeup of the DAX has sufficiently changed to release it from the shackles of being a play on global growth. When we look at the year on year change of copper, often considered to be a proxy for the state of global economic growth, compared to the year on year change in the DAX, the two have tracked each other pretty well over the last decade. Recently, the DAX has significantly outperformed the price of copper, as you can see on this chart of the absolute performance of copper versus the DAX over the last five years. So therefore has it decoupled? Last week we highlighted some key levels in copper and oil. Financial assets such as equities have been soaring, but real economy assets such as industrial commodities are close to breaking down, indicating the true debilitating impact that the coronavirus is having not only in China but on global demand. The DAX does look vulnerable, but will central banks continue to successfully prop up financial markets? The European auto sector the SXAP is close to a major support level, though I would play this through put options because for now, developed market equities are still trending higher. And rather than playing this from the perspective of an outright position, maybe relative trades would be preferable, such as a long of the FTSE100 in the UK or even the less liquid AEX of the Netherlands, versus a short in the DAX. And the DAX does have dividends reinvested as part of that index. So comparing the DAX with the FTSE or AEX is not quite apples with apples. DAX, volatility is at the lower end of its long term range. Now, that doesn't mean it's cheap. The implied volatility, what you pay, is roughly in line with the historical volatility of the index, but it is attractive on a relative basis versus e.g. volatility on the S&P 500. For most of the last 10 years, DAX volatility has been higher than the S&P 500 volatility. But over the last year, DAX volatility has regularly been below that of the S&P 500. Therefore, if we are looking for a global hedge to the current outlook, the DAX offers some of the best global risk reward. But given this bizarro world in which equities prosper when economies fade, perhaps a short position in the euro should be considered. Although we have seen bouts of risk aversion via strength in the euro, the Swiss franc and the Japanese yen, the euro has continued to break down over recent days. The consensus for Europe into 2020 was probably for a V shaped recovery, a rebound from the 2019 slump. And I think much of this was predicated on the back of a renewed liquidity cycle, particularly the one emanating from the PBoC in China and that nascent bottoming out in global PMI eyes towards the end of last year. The US, however, is also likely to turn its trade attention towards Europe, and Europe has got a history of being stubborn and pushing back against this sort of aggression itself. Now, that might not be the right policy under these circumstances. If problems with China persist, then Europe will be wanting a weaker euro to help its export-based economy recover. In reality, the euro and the US dollar have been grinding out a relatively tight trend. Currency volatility is at record lows, as indicated by the CVIX, which is the Deutsche Bank FX volatility index. But the euro should return to test the trend, and if the virus outbreak spreads, we should see the bottom of that trend line come under pressure. And I would certainly favour the Japanese yen or the Swiss franc over the euro if I wanted to find a safe haven currency. Germany and Europe have not made structural changes that are required for lasting growth and are in effect at the mercy of the kindness of strangers i.e. foreign demand for European goods. And that's not about to take off anytime soon. There's a lot of chatter about the effect of central bank liquidity versus the reality of the Corona virus outbreak. And this is one of the reasons it's been so very difficult to nail down an investment strategy in this environment. Regardless of whether we think the worst is still to come or the worst is now over, we should still focus on the stocks and sectors that have been in the firing line. We may be more worried about the impacts outside China. But does any of this matter if central banks return with an aggressive response? And can a global crisis be overcome with liquidity? Well, that's the massive unknown. The following Refinitiv charts can help to frame the outlook. Firstly, let's look at the global macro backdrop. Before this outbreak, global PMIs looked like they were attempting to turn higher after dropping through 2018 and early 2019. And the narrative in mid 2019 was that declines in bond yields had heralded or were heralding a global recession, even as central banks returned to the fray. Emerging market central banks were firmly in easing mode, particularly when yields were close to their lows in August and September of last year. And by that time, the central bank response was already well underway. This was a re-loosening of financial conditions, and loose conditions have generally been supportive of asset prices, especially those financial conditions have been close to record lows. But then, of course, coronavirus swept through the narrative reported cases where around 40,000 as of Monday, the 10th of February, at which time it was alleged that the number of new cases within China was at least beginning to stabilise. Although the global spread is significant, the obvious focus is clearly on China, because the reported cases outside of China are still in the tens rather than the hundreds by countries so far. But is this just the tip of the iceberg? Well, no one really knows, do they? We've already noted the massive disparity between the real economy demand for such items as oil and copper versus financial asset demands such as equities, which have been bad for all risk assets, has been trumped by liquidity as the driving factor. And financial assets absolutely love liquidity. The response from the PBoC, the Chinese central bank was swift with a massive injection of seven day reverse repo, basically short dated liquidity and also a cut in short term borrowing rates. And whilst real economy assets like commodities have been stuck near their lows, equities in many developed markets have been retesting their highs. The assumption is that we're going to get a V shaped event, a short, sharp shock followed by a rapid recovery as was experienced during the SARS event of 2003 as can be seen in the rebound in the Hong Kong PMI and China retail sales of that period. And obviously, if you want to be sensationalist, it's pretty easy. The total death toll for this year's outbreak has already surpassed the death toll for the 2003 SARS outbreak. And it's taken only 26 days this time versus 73 days to record those deaths, back in 2003. Is this the beginning of the end? Or is it the end of the beginning? Which stocks and sectors have the most exposure and which are therefore most likely to react in either direction? As of Monday, stocks in the luxury sector such as Swatch had rebounded off their lows. The same thing was true of BHP, the mining company, which allegedly has the highest sales exposed to China. Markets are acting as if the outbreak is contained, with many sectors successfully rebounding. But which companies are most exposed to China as a percentage of total revenues? The mining company BHP has the highest exposure, followed by the tech company ASM from the Netherlands and then another miner, Rio Tinto. And it's no surprise that mining and luxury names feature heavily on the list in terms of the greater exposure by total revenue. Glencore another miner, Shell and BP have the highest footprint, but also car makers such as BMW, Daimler and even Peugeot, are featured here. Luxury brands are obviously deemed to be vulnerable to a slowdown and should have the most to gain from an end to the fear factor. Swatch, Richemont and Burberry have over 40 percent of total sales in China and UBS Investment Bank consider that Swatch have the highest EPS impact if Chinese demand falls by 30 percent…… and that's represented by the red dot on this chart. Clearly, whilst we don't know the outcome of a virus outbreak and whilst we don't know the central bank's response we at least need to know which are the stocks and sectors which should have the greatest reaction in both directions. If this outbreak builds momentum, mining and luxury names clearly have the most to lose, whilst any rebound from here, because we've already seen some gains, that rebound will probably be relatively muted. In the very first episode of The Big Conversation, we talked about the impact the balance sheet charges were having for global systematically important banks or GSIB banks. And we suggested at the time that the tightness in the repo market, that’s the overnight or short term funding markets, would lead to a relaxing of these GSIB rules. Well, as we now all know, instead of relaxing the rules, the authorities, in this case the US Federal Reserve via the New York Fed, provided an excess of liquidity. You can call it QE or not QE depending on your desire. However you want to define it, the fact was that equities made new all time highs or made new highs in a lot of countries. And this liquidity injection was probably a key influence behind, for instance, things like the initiation of Tesla's short squeeze last year (though this is in fact taken on a life of its own in recent weeks). Central banks used to primarily focus on the cost of capital i.e. interest rates, whereas today they focus maybe not totally, but a lot more on the availability of capital, as long as inflation remains subdued. So what is the Fed currently doing? Having injected so much additional liquidity between the 14th of December 2019 and the 14th of January 2020, have they been taking the foot off the pedal? Well, the answer is no, not yet. In absolute terms, the Fed's balance sheet has been flat lining recently. In terms of the rate of change of the balance sheet, the equity market has generally been ebbing and flowing with the rise and the fall of that balance sheet. In fact, we've seen two consecutive weekly gains in the Fed's balance sheet and this has helped the S&P make quite a stunning week on week gain. And it's a reminder that for equities, in many ways, earnings don't matter. Viruses don't matter and economics don't matter. At least they don't as long as the Fed is still stuffing the channels with liquidity. Understanding their exit strategy, if there is one, is going to be a key input for helping to understand future equity performance.