Restructuring in Germany at both the macroeconomic and microeconomic levels is now about to pay off. At a corporate level, the share of profits as a percentage of national income has already increased from 36% to 39% since the start of the decade.
This means that German companies, having already done much to relocate production costs in lower-wage economies or to promote flexibility amongst their unionised workforces, are fundamentally in very good shape. The euro has been a tremendous boon for German manufacturers, who have been able to clamp down on unit labour costs unlike many of their, for example, Italian competitors, who have no longer been able to devalue their way out of difficulty.
And the influence of shareholders over the direction of German corporates, at the expense of management and unions, has increased markedly over the past year (e.g. Deutsche Brse, Volkswagen and Daimler-Chrysler).
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The main problem with the German economy in recent years has been the obverse of some of the problems associated with the US too much saving. The saving rate in Germany is now roughly 10.5%, an extremely high level that has been brought on in part due to concerns over rising unemployment and government spending cuts on healthcare, welfare and pension provision. This rise in the savings rate can be seen in the share price performance of some of the smaller German asset gatherers such as AWD.
Furthermore, the German savings market has been historically heavily skewed away from residential property (the most common form of saving in the UK) and the equity market in favour of increasingly low-yielding bonds and other financial instruments. Several factors are now likely to push some of these pent-up savings in the direction of equities in the forthcoming months.
Firstly, there is the prospect of federal elections in Germany. We believe that these have the potential to be meaningful. This is not necessarily because the Christian-Democratic Union (CDU) and the Bavarian Christian-Social Party (CSU) alliance is any more pro-reform than the Social Democratic Party (SPD), but because there is a real possibility that, in coalition with the Free Democratic Party (FDP), the conservatives might end up with control over the executive branch of government and both houses of the legislature.
A log-jam in the legislature has been one of the principal reasons why Chancellor Schrder's reforms have been only half-hearted. Certainly, a victory by the CDU, CSU and FDP would be treated as good news in terms of investor sentiment by both domestic and foreign investors. Also, as part of their programme, the conservative coalition has already said that it would remove the tax breaks associated with some savings products. This would create much more of a level playing field for equities versus other investments. Coincidentally, this comes at a time when the 3 and 5-year performance of equities is beginning to look rather good against alternative asset classes.
Importantly, this divergence between the performance of equities and bonds is likely to continue to widen further in favour of equities in the forthcoming months. German investors scared off by equity market volatility may well now dip a toe back into the stock market and, specifically, the German stock market the equity revolution was not cancelled, merely deferred.
Finally, there is now a serious prospect of a gradual rebound in German consumer spending, which up until now has been the weakest part of the German economic story. Home ownership in Germany has historically been low by European standards (42% versus a euro area average of 60%), but it is now rising as vulture funds and predominantly foreign private equity companies buy up large amounts of housing stock from German corporates, gradually selling them on to tenants.
Tenants are willing to buy because with interest rates at these levels their mortgage payments are more or less the same as their rents were. Banks are increasingly able to lend because they have tightened their belts during the downturn and now have more capital available.
This is positive for consumption for two reasons. Firstly, because consumers feel that making mortgage payments is effectively paying into their savings, they feel comfortable spending more of their remaining monthly income (i.e. the savings ratio can fall).
Secondly, home ownership itself drives increased consumer spending on domestic appliances and home furnishings. Exactly the same mechanism has fuelled the consumer boom in the UK, Spain and Ireland over the past decade. Though the UK might be at the tail-end of this particular story, Germany is likely to be at the beginning A rebound of the German consumer would, however, just be the icing on the cake. Goldman Sachs calculates that German equities trade more or less in line with the European equity market on a sector adjusted P/E basis, which we think is cheap short-term earnings growth is likely to be stronger in Germany, given the cyclical nature of its economy and continued strong global economic growth.
So we are seeing the convergence of several positive factors for German equities. In the economy, corporate profitability has improved thanks to restructuring; the upcoming election presents a realistic prospect of breaking the legislative log-jam that has hampered the pace of reform; and increasing home ownership may well provide a spur to German domestic consumption, as has been the case in other European countries.
For the stock market itself, the election result could result in the removal of certain tax incentives to invest away from equities, at a time when returns from Germany's stock market versus other investments look increasingly attractive to investors.
By Dave Dudding, Fund Manager at Threadneedle European Equit
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