GavekalResearch The Daily

October 4, 2019
Page 1

The German Spillover

Nick Andrews
nandrews@gavekal.com
The eurozone is slowly switching to more
expansionary fiscal settings...
...but too slowly to prevent Germany’s
manufacturing slowdown from spilling
over to the broader German economy
Perhaps the most remarkable thing about this year’s slump in manufacturing
is how few negative spillover effects it has had on demand in the broader
economy—until now. Consider the eurozone and its largest member
Germany: although manufacturing PMIs have been sinking deeper into
contractionary territory since the beginning of 2019, the PMIs for services
remained firmly positive through the end of the summer. This may now be
changing. Services PMIs for both the eurozone as a whole and for Germany
took a sharp turn south in September. In Germany, the deterioration was
steep enough to push the composite PMI into contractionary territory below
50 for the first time since 2013, making a technical recession all but inevitable.
For investors, the news is not necessarily all bearish. As Anatole outlined on
Monday, the eurozone is slowly moving away from its “perversely procyclical”
settings towards a greater willingness to pursue more expansionary fiscal
policies in a downturn (see The Upside For Europe). This could prove a
powerful change; the relative strength of French growth this year compared
with Germany demonstrates how effective fiscal policy can be in supporting
activity. And as the icing on the cake, any deal on Brexit would remove a lot
of uncertainty, significantly boosting sentiment.
For now, however, there appears a sizable chance the Brexit uncertainty will
be prolonged past the UK’s scheduled October 31st departure date well into
2020. And in Germany especially, engineering a switch to a more counter-
cyclical fiscal policy will take time, and will only be achieved by overcoming
formidable domestic resistance. Unfortunately, as this week’s PMI surveys
indicated, time is not on the German economy’s side. With growing signs
that the country’s manufacturing recession is finally spilling over to the rest
of the economy, it is likely that the picture for both German growth and risk
assets will darken considerably before there is any chance of a significantly
more expansionary fiscal policy coming through to support demand.

Checking The Boxes

Our short take on the latest news
Fact
US ISM non-manufacturing
PMI fell to 52.6 in Sep, from
56.4 in Aug
Eurozone composite PMI fell
to 50.1 in Sep, from 51.9 in Aug
UK composite PMI fell to 48.8
in Sep, from 50.2 in Aug
Turkey CPI rose 9.3% YoY in
Sep, from 15% in Aug
Consensus belief
Lower than 55.0 expected
Below 50.4 expected; Ger 48.5
(from 51.7), Fra 50.8 (52.9), Ita
50.6 (50.3), Spa 51.7 (52.6)
Below 50.0 expected; services
fell to 49.5, from 50.6
Below 9.7% expected; core CPI
slowed to 7.5% YoY, from 13.6%
Our reaction
Watch for signs of mfg weakness
spreading; for now, the broader
economy remains healthy
Spillovers from mfg to services
may accelerate as a dearth of
new mfg orders leads to job cuts
Economy sustained by consum-
er spending, but weakening
labor mkt depresses the outlook
CBRT has leeway to cut rates
without triggering a renewed
sell-off in TRY

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 GavekalResearch
So far German manufacturing employers
have been reluctant to lay off workers...
...but with profits sliding and orders
evaporating, cost cuts cannot be far off
Germany will be slow to follow France’s
fiscal example
The Daily
October 4, 2019
Page 2
The main reason Germany’s industrial slump has been so slow to spill over
to the wider economy is that so far employers have been reluctant to respond
to declining new orders and falling profits by cutting costs through laying
off workers. This is partly because even though industrial output was falling,
it remained high in absolute terms, reflecting a backlog of orders associated
with China’s 2016-17 stimulus. And doubtless the reluctance to cut headcount
also partly reflects the structural tightening of the German labor market over
the last decade or so, which has made skilled workers harder to recruit and
more valuable to retain (see Auf Wiedersehen, German Competitiveness).
Whatever the precise balance of reasons, manufacturing sector employment
has barely changed over the last six months, and the overall German
unemployment rate remains at a post-unification low of just 3.1% even
as wages continue to push higher in real terms. This combination of solid
manufacturing employment and rising wages has helped to support consumer
demand and therefore activity in the broader German economy.
However, with profits in the manufacturing sector down -11% year-on-year
in the second quarter and new orders continuing to slide, it cannot be long
before companies begin to lay off workers in earnest, with all the consequent
negative effects on consumer confidence and activity in the broader economy.
The trend in Germany is reflected—albeit to a lesser degree—across much of
the eurozone. The notable exception is France. This year French demand has
been supported by income tax cuts, and corporate profits have been boosted
by €20bn of cuts in employers’ social security contributions. And next year
disposable income will be further supported by another €9bn in tax cuts. In
Germany, too, an easier fiscal stance could support demand, and at relatively
little cost (see Draghi’s Fiscal Gift and Germany’s Fiscal Firepower). But
on current form, Berlin is unlikely to act until unemployment has risen
significantly, and growth has deteriorated a good deal further.
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