What follows is a “subscriber op-ed”, written by Rebecca Patterson, the former chief investment strategist at Bridgewater Associates, the world’s largest hedge fund. It’s an analysis of Germany’s current economic malaise and what might turn things around. Germany as “the sick man of Europe” (again) is a real concern. Germany and France anchor the European Union.
It’s well known that Germany has again become the “sick man of Europe.” Its economy contracted in 2023 and is only expected to eke out 0.1% annual growth this year (according to Bloomberg consensus forecasts). Since the pandemic, Germany has significantly underperformed the broader Euro Area and OECD developed economies.
What’s less clear is how and when the world’s fourth-largest economy and the anchor of Europe recovers. Thinking through a prognosis for Germany prompts at least three questions.
First, how did Germany find itself in this unenviable position? Clarity on this point can help define what is needed for an economic recovery and its probability in the foreseeable future.
A related question is whether Germany’s economic health is a priority for other countries within or outside Europe, and how. Given dependencies and policies that encompass the broader Euro area, a German recovery will depend in part on the decisions of Europe’s leaders. US policy choices after the November election could also shape Germany’s economic prospects.
Finally, there is a question about the contrast between the country’s record-high DAX equity index and anemic underlying economic growth. Digging into this dichotomy sheds light on possible paths to a German recovery, why such a recovery may prove difficult to engineer, as well as what makes sense as an investment approach to Germany.
Europe’s “Sickness” Both Cyclical and Structural
To understand what’s ailing Germany, it’s useful to start with a simple framework: economic growth as a function of labor and productivity. Broadly speaking, GDP growth is a sum of the number of workers in an economy and output per worker.
At first glance, the labor side of that equation looks decent. Germany’s labor force is growing and expected to continue to do so for at least the coming year, according to OECD forecasts. The challenge is that growth is being driven by foreign-born workers, including particularly large influxes of immigrants in 2015-16 and thereafter the start of the war in Ukraine. (The native-born German population has been shrinking now for decades.) The share of foreign-born workers in Germany today is near 16%, one of the highest rates among advanced economies.
Increasing voter pushback to the record number of newcomers has resulted in recent government decisions to more strictly control immigration. Efforts including the imposition of tighter border controls may help politicians’ approval ratings but will risk this key source of labor-force, and ultimately, economic growth.
The productivity side of Germany’s growth equation, meanwhile, is dire. Using OECD data, productivity growth has averaged around zero for more than a decade, substantially lagging growth in the US.
Productivity can be influenced by a myriad of factors, including technology, worker skills, investment, business processes, and culture. Germany appears challenged, in absolute terms and relative to peers, across most categories.
On technology and job skills, Germany has not been able (so far) to take its historical excellence in advanced manufacturing and adapt it to a quickly evolving technology landscape. An illustration of this comes from a July 2024 EY survey of more than 4,700 people across Europe about implementation of and sentiment towards artificial intelligence (AI). Germany ranked near the bottom of the countries in terms of AI deployment to date and an interest in gaining AI skills in the workplace (Switzerland tended to be Europe’s AI leader, at least in this survey.)
Meanwhile, Germany is not seeing much public or private-sector investment in productivity- enhancing corners of the economy, such as infrastructure and research and development. According to the IMF, German gross public investment averaged less than 3% of GDP between 2018-22, only higher than Spain when looking across developed economies.
That relative lack of public investment is largely self-inflicted. Germany’s so-called debt brake is even more stringent than the Euro area’s deficit and debt guidelines under the Growth and Stability Pact. It sets a maximum budget deficit of 0.35% of GDP for when the economy is growing at its highest sustainable rate (a so-called structural deficit).
Not surprisingly, then, Germany depends heavily on private-sector investment to support business growth and innovation. That investment has taken a few hits in recent years, from the pandemic as well as from passthrough from the war in Ukraine (notably higher energy costs and worries over energy supplies). Alongside relatively challenging wages and regulation, foreign firms have been shying away from Germany. Foreign direct investment (FDI) to the country fell 12% last year, continuing a decreasing trend since the start of Covid. Local firms have been unwilling or unable to fill that investment gap.
If there is some good news here, it’s that most of Germany’s economic hurdles are surmountable. Regulations can be eased, immigration processes can be improved, government fiscal rules can be amended. Indeed, history shows Germany has made politically unpopular decisions before in the name of growth. Facing a stagnant economy with a double-digit unemployment rate in the early 2000s, German Chancellor Gerhard Schroder announced a series of reform measures starting in 2003 around the labor market (the “Hartz reforms”) and social safety net. While politically unpopular, the multi-year efforts helped bring the unemployment rate to below 7% by end-2011.
Today, unfortunately, it seems unlikely that Chancellor Scholz would implement politically unpopular reforms given his extremely low approval ratings and a tenuous leadership over a three- party coalition, the latter making passing any legislation difficult.
Could Outside Pressure Force Internal German Change?
In thinking what could change dynamics within Germany, it’s worth looking beyond the country’s borders. More than half of German GDP comes from exports, so policy change among key trading partners could influence Germany’s economy directly or provide cover for the German government to take politically difficult growth-oriented steps.
The European reform proposals laid out this year from former European Central Bank President Mario Draghi and former Italian Prime Minister Enrico Letta – among other things, taking steps to reduce energy costs, pushing forward on European capital market and banking unions to support business growth, reducing regulatory burdens and encouraging innovation - would undoubtedly help Germany. But progress on these proposals cannot be achieved just by a well-intentioned European Commission. Reforms must be embraced by the member states as well, and so far Germany has been skeptical, especially around idea of more European debt.
External catalysts have allowed for sudden German policy changes before. Just in the last few years, the pandemic opened the door for German acceptance of regional debt and additional local and European spending, while the war in Ukraine prompted what Chancellor Scholz called a turning point on defense policy – the government has since increased defense spending and provided weapons for Ukraine.
Could the US presidential election provide another catalyst for action? In the case of victory for former president Donald Trump, Germany could expect increased tariffs on its exports to the US of 10% or more (US exports currently account for around 9% of the country’s total). The German Economic Institute (IW), in a report published this March, estimated that Germany’s economy would contract at least by 1.2% by 2028 in such a scenario, with downside risk if retaliatory tariffs around the world weighed further on global demand. In addition, Trump has suggested a possible reduction in US support for NATO and a desire to end the war in Ukraine – both could have material impacts on Germany that could prompt a government policy rethink.
The Market-Economic Divide Illustrates Germany’s Potential and Challenges
With so many challenges facing Germany’s economy, it is surprising – at least at first glance – that the country’s equity market has posted double-digit gains so far in 2024, flirting with record highs.
Digging a bit deeper, though, the divergence makes more sense and reflects both Germany’s potential but also its challenges. Over longer time periods (10-15 years), domestic economic growth has been shown to be one of the largest drivers of a country’s equity performance. In Germany’s case, that means that local stocks should underperform if the economy keeps struggling for the foreseeable future.
Over shorter time frames, though, other factors can dominate market returns. For much of last and this year, one such driver has stood out: technology and especially artificial intelligence (AI). Germany’s leading software technology company, SAP, has been particularly popular for investors wanting globally diversified AI-related exposure. In the year through early October, the stock has gained around 40%, versus the DAX index’s 14%. That follow’s another 45% gain for SAP last year.
SAP’s success, helped by cloud revenue growth, shows Germany’s corporate potential in an AI age. However, SAP’s relatively unique status in the country as a “mega-cap” tech company also highlights some of the challenges facing Germany and Europe more broadly.
One key challenge is access to capital, as highlighted in the September Draghi report on European competitiveness. The report notes that between 2008-2021, 147 unicorns, startups that grew to be valued at more than USD1 billion, were founded in Europe, but that 40 relocated their headquarters outside of the region. Draghi suggested that fragmentation within the EU, including within capital markets, has made it more difficult for start-ups to grow, and that moving to the US allows for easier capital access as well as market reach to achieve profitability more quickly.
The report’s points were underscored in a recent report from OMFIF, a think tank. It showed that banks provide about 70% of total financing to European firms. That makes corporate lending more sensitive to macro conditions that can influence banks’ ability and willingness to lend. In contrast, US banks only provide about 30% of the country’s total corporate financing. The rest comes from a wide variety of non-bank institutions and capital-market alternatives. A small business in the US will have relatively cheaper, easier-to-access capital across a business cycle. Over time, that will add up.
For investors, Germany is a cautionary tale of focusing on security selection and avoiding broad index exchange-traded products, at least near-term. For policymakers, history shows that Germany’s economy need not remain sick and a drag on Europe more broadly. Draghi, Letta and others have shown possible ways to get there. German leaders just need the willingness (and the fortitude) to make changes. Whether they will is the open question.