Will the German stock market rally last?

German investors were ready to uncork the champagne last week. Thanks to strong global and local economic growth, the benchmark DAX index was rapidly approaching its record close of 8,065, set in March 2000. But then global jitters suddenly wiped 4% off the market. So what next?

The macroeconomic backdrop remains auspicious, with the erstwhile "sick man of Europe" spearheading a strong European recovery. After 2.8% growth in 2006, a similar figure is on the cards for this year. The strong global economy has boosted exports, which were up 13% year-on-year in April, while corporate spending on equipment rose by the most in seven years in the first quarter. The export-led recovery is slowly broadening beyond business investment to consumption as unemployment declines. Retail sales in April posted the biggest gain in four months. "It's the consumption side of things that's getting people really excited now," says Rob Burnett of the Neptune European Opportunities fund.

Underlying all this has been a "painful transition", says Algy Hall in Investors Chronicle. Companies have outsourced, restructured and negotiated flexible working arrangements with unions; DaimlerChrysler, for instance, has cut head-office staff by a fifth. German unit labour costs have dropped by 10% over the past decade, making exporters more competitive and helping to "kick-start the recovery process". The resultant improved profitability also makes German firms more resilient to the euro's appreciation than most of their European counterparts, according to Bernd Meyer of Deutsche Bank. "Germany is one gigantic restructuring story we just kept finding good value," enthuses a US fund manager.

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Average 2007 earnings estimates for the German firms in the pan-European DJ Stoxx 600 index have climbed to 9.3% compared with 6% for non-German firms. Meanwhile, the DAX's p/e of about 14 is below that of many major counterparts. According to Iain Bokobza of Socit Gnrale, German stocks are being rerated as performance improves, a process that is far from over.

Admittedly, the economy's earnings boost from restructuring is fading, while signs of a weaker world economy, rising interest rates and turbulence in global markets are all risk factors, says FT Deutschland. The market's best days might be behind it however, given the solid fundamentals and the fact that retail investors have hitherto shied away, the rally "should go on for a while".