Why a German recession would be good news for cheap stocks

As the rest of Europe continues to suffer, Germany is now starting to feel the pinch. Matthew Partridge explains why that should be good for stocks, and picks the best ways to profit.

European stocks soared yesterday. At first sight, it doesn't seem to make much sense.

The economic situation in Europe just keeps getting more miserable. Yesterday we learned that even the strong' northern countries the ones who are meant to be paying for all the bail-outs are feeling the pain.

The latest data showed that business activity in Germany slowed last month. Both manufacturers and service businesses are having a tougher time. The country may even be close to recession.

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And yet, stocks in the region moved higher. Italian and Spanish stocks in particular shot up.

Why all the excitement? As usual, it boils down to one thing the promise of money printing

Germany and France are feeling the pinch

Up until now, there's been one big argument for the European Central Bank (ECB) to print money because the weaker eurozone countries need the help. They need a weaker euro, and they need a bit of inflation to help them get their debt levels under control.

The trouble is, German fears about inflation and about being forced to pay for the profligates' of southern Europe have prevented the ECB from acting.

And as we all know, Germany's political power means that its views trump anyone else's in Europe.

However, things could be about to change. Because the Germans are starting to struggle too.

The Purchasing Managers Index (PMI) survey is a nice timely snapshot of business activity. The survey produces a score of between 0 and 100. Above 50 suggests the economy is growing; below 50 suggests it is shrinking.

The PMI survey has a close relationship with GDP. It's pretty reliable. So if the PMI survey points to slowing activity, you can expect economic growth to disappoint too.

So the fact that the most recent French and German scores came in at 44.2 and 48.8 respectively are clear signs that the two largest eurozone countries are not immune from the crisis.

And if you look at the German data in more detail, it doesn't seem as if things are going to get better any time soon. The sub-index dealing with the backlog of work, which indicates future demand, has been going down for nearly two years.

German resistance to money-printing will falter

So why is this good news?

German voters go to the polls in September. Until now, Angela Merkel's main worry has been that she'll be seen to be soft on the European stragglers. German taxpayers don't like the idea that their hard-earned money is going on bail-outs. So far, Merkel is doing pretty well - she is far ahead of the rival SPD in the polls.

Yet Germany's voting system means that there is still an outside chance of a Red-Green coalition on the left. And there is also a threat from the right, in the form of the anti-euro Alternative for Germany' party. Already this group has enough votes to get into parliament.

So if the German economy starts slowing now too, Merkel's party could be squeezed from both sides so much that she is forced into a grand coalition'. This would make her last few years in office a nightmare.

In France, Francois Hollande is also facing pressure. With his budget minister forced to quit for tax dodging, and his tax plans in chaos, his popularity is in free-fall. Some polls put his approval rating as low as 26%.

While he doesn't face an immediate election, low ratings will make it harder for him to push through further reforms. It will also make his task much harder in four years' time.

If both Germany and France start worrying more about a slowing economy than about punishing the southern Europeans, then their opposition to money-printing is likely to fall.

Already, Mario Draghi has been hinting at a possible rate cut. Yet with eurozone rates already at 0.75%, they don't have that far to fall. And compared to its global peers, the ECB is already way behind on monetary policy.

All the signs therefore point to the eventual launch of quantitative easing (QE). As we've pointed out before, this will hit the value of the euro. While this will be welcome news for European firms selling abroad, it is bad news for those holding fixed income assets, such as bonds, denominated in the single currency.

If you want to short the euro against the US dollar is probably the best bet you could use a spread bet. To find out more about spread betting, sign up for our free MoneyWeek Trader email.

For a more long-term investor, we'd be looking at cheap eurozone assets. As we've seen elsewhere, money-printing tends to boost the price of assets, particularly if they're cheap to begin with. So while the currency might fall, any currency losses are more than compensated for by the rise in the value of the underlying assets. Just look at Japan.

We'd stay away from property, despite the tempting prices. The problem is that immobile assets such as houses or land are too tempting a target for cash-strapped governments. This means that they will be targets for taxes, which are already hitting households in Ireland and France.

However, shares are a different matter. Despite their rise last summer, Greek and Italian equities are still dirt cheap especially if you use look at their earnings over ten years. Greece and Italy trade at three and seven times their average earnings over the past ten years respectively. Exchange traded funds that cover these countries include Lyxor Athens ETF (Paris: GRE) for Greece and iShares FTSE MIB (LSE: IMIB) for Italy.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri