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Thursday, January 19, 2006
Germany's Upside Potential
Why was former Chancellor Gerhard Schroeder smiling broadly in all those pictures with Chancellor Angela Merkel? He knows just how tough it is going to be to turn the German supertanker around with an unwieldy left-right coalition at the controls.
Americans should thank heaven each morning that they have only Democrats and Republicans to worry about. Multi-party coalition governments are infinitely more difficult to manage. Consider this: the agreement between Germany's ruling coalition is 190 pages long.
Making everything more difficult is the contradictory policies of the new government. The coalition's stated primary goal is to create jobs and bring the 11% unemployment rate down but it also plans on raising taxes to reduce the budget deficit which has missed the European Union's fiscal rules for the fourth straight year. In addition, plans to reduce Germany's corporate tax rate and radical labor reforms have already been put off to 2008.
The gateway to growth is in the hands of the German consumer who is by all accounts "conservative". Polls show that most have very low expectations of the incoming government. 61% believe that German's economic situation will be worse four years from now and only 16% believe that Chancellor Merkel can sharply decrease the unemployment rate. No wonder consumer spending has decreased three quarters in a row.
Germans know that they need to make some significant changes but are resistant to dismantle the expensive social net and inflexible labor regulations that hamper German growth. The key issue is the former East Germany. Germany has poured $1.5 trillion into the region and unemployment is still about 19%. Instead of taking advantage of its lower wage structure, German unions rushed to unionize East German workers that did not have the training, skills or mindset commensurate with their jump in wages.
The brightest spot for Germany has been exports of industrial goods with especially strong exports to China. But this is changing as China makes more of these capital goods itself. In the last 12 months, Chinese exports to Germany have risen 40% while German exports to China have risen a paltry 2%. Germans have a high savings rate of 11% of income and GDP growth has averaged only 0.5% during the last three years.
I have painted a rather bleak picture so why have I recommended a modest allocation to the German iShare since May 2005?
The first reason is very low expectations. Any improvements, even marginal, will have a positive affect on markets. Secondly, the overall market is not expensive at about 14 times earnings. Thirdly, the German companies that dominate the holdings of the Germany iShare are world- class multinationals and are more tied to booming Asia than to the slow growth German economy. Large German multinationals are shedding high cost and inflexible German workers. Siemens, Deutsche Telecom, Allianz, Deutsche Bank, DaimlerChrysler, Bayer and BASF account for 50% of the holdings of the Germany iShare (EWG).
Furthermore, with the Euro down 12 % this year and at a two year low against the U.S. Dollar, the world's largest exporter is picking up some steam. The top line numbers from leading German industrial companies are rolling in with impressive numbers for an almost zero growth economy. Siemens quarterly sales rose 13% - the fastest since 2003. BMW's sales rose by 11% in the third quarter although high raw material costs and pricing pressure resulted in weak net profits. A bright spot is Asia where BMW expects to sell 150,000 cars per year by 2008.
Overall, German exports are up for the third straight month and sales to countries outside of the European Union rose 18% annually from a year earlier. Clearly the Germans are good at making stuff and selling it to the world and the weaker Euro is helping spur growth. Germany's DAX stock index is taking notice and was up 7.7% in 2005.
The German economy is a huge restructuring play that will take many years to bear fruit so investors should go with large German multinationals such as Siemens that are not waiting for the politicians to tell them what to do. They are searching the globe for opportunities and winning big contracts and profits for shareholders.
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