Germany’s business climate has suffered by less than feared from the Brexit decision.
Implications | Mixed evidence across industrial and trade sectors and encouraging service-sector improvements suggests that the Brexit event will not damage German economic growth momentum as much as had been feared. Robust domestic demand acts as a shield, but even manufacturing exports appear relatively resilient. |
Outlook | In its July forecast round, IHS Markit has reduced its predictions for German GDP growth from 1.9% to 1.6% for 2016 and from 2.0% to 1.4% for 2017. The latest Ifo and PMI releases suggest this downward revision was somewhat overdone. |
In July, the headline Ifo business climate index reflecting conditions in industry, construction, and wholesale and retail trade retreated from 108.7 to 108.3. This reflects a considered reaction to the UK referendum decision of 23 June to leave the EU and the decline is much milder than had been feared. The level of 108.3 compares with a long-term average of 101.7 and remains close to the interim peak of 109.0 seen in November 2015. Historic extremes are a low of 83.5 in March 2009 in the wake of the Lehman collapse and an all-time peak of 114.3 in November/December 2010. Most of the recent rebound of the Ifo index observed since March thus remains intact, suggesting that near-term German economic growth momentum will not be hurt unduly by Brexit. The Ifo evidence is consistent with a similarly limited decline of the manufacturing PMI leading indicator in July. Indeed, services PMI had even improved this month, and only the ZEW indicator with its traditional sensitivity to financial market developments revealed a major decline. The Ifo institute comment on the latest data by saying that the German economy is "demonstrating resilience".
Following a four-month rebound by altogether 4.1 points, the expectations component of the Ifo business climate survey slipped from a six-month high of 103.1 to 102.2. This is a surprisingly mild reaction to the Brexit event, which should be fully captured by the July survey given the timing of the referendum. The level of 102.2 still exceeds the long-term average of 100.3. Meanwhile, July’s current conditions component actually increased slightly further from 114.6 to an 11-month high of 114.7, getting close to the interim peaks of 115.1 in August 2015 and 115.4 in March 2014. The current conditions sub-index thus remains far above its long-term average (103.2), as is also underscored by the fact that the most recent downward correction of some length (during April–October 2014) only extended to 108.2, never even getting close to its long-term average. However, the all-time record of 121.9 seen in June 2011 is not in danger any time soon, especially given the additional uncertainty introduced by political developments lately (Brexit; political instability in Turkey).
Today's separate Ifo survey release about the climate in the service sector -– a series available since January 2005 – has increased slightly further from 27.3 to 27.6. This index had declined from an all-time high of 34.5 in December 2015 to an 11-month low of 24.7 in March before recovering partially in subsequent months. In July, there was a sharp dichotomy between a setback to current conditions (from 41.0 to 36.1) and a sizeable further recovery of expectations (from 14.4 to a six-month high of 19.3). The latter had reached an all-time peak of 26.3 in November 2015 before weakening to an interim low of 13.1 in March. Current conditions, which had deteriorated by a much more limited amount in early 2016 (from 44.9 in December to 36.9 in March), are now broadly back at their March level. Expectations and current conditions both remain above their long-term averages of 11.1 and 23.6, respectively. The bigger picture reveals that the overall service-sector index unwound the break-out to the upside observed in the second half of 2015 during Q1the first quarter of 2016, but has now stabilised at levels that exceed most of what was observed between the start of this series in 2005 and 2014. During the eleven years of history of this service sector series, expectations have fluctuated between -25.5 (December 2008) and 26.3 (November 2015), and current conditions between -12.7 (May 2009) and 45.4 (September 2015).
Sector breakdown reveals diverging developments across sectors and time horizons
The breakdown of the main Ifo survey by sector, relating to goods production and trade, reveals a split picture. The climate in manufacturing and wholesale trade deteriorated whereas the construction and retail sectors showed improvements. There was no uniform picture with respect to the roles of current conditions and expectations either. Thus worsening sentiment in the manufacturing sector was driven exclusively by expectations whereas in the wholesale sector an unwinding of June's spike in current conditions was to blame. Conversely, July construction sector improvement was propelled by expectations, whereas the retail sector gain was purely down to rebounding current conditions.
The details show that business climate in the manufacturing sector slipped from a six-month high of 10.9 to 9.8, driven by expectations alone. This was most pronounced in the automobile sector, where expectations even turned outright pessimistic. By contrast, current conditions increased anew, accompanied by an increase in capacity utilisation from 84.4% to 84.7%.
The other sector to show deterioration in July was wholesale trade. Its index declined from 15.1, which had almost matched the November 2015 22-month high of 15.3, to 11.8. This drop was due exclusively to current conditions, which unwound June’s increase that had taken the sub-index to its highest level since February 2012. Expectations remained roughly flat, in line with the sideways tendency of the overall index of wholesale trade seen since mid-2015.
The construction sector climate increased anew from 4.8 to a post-unification all-time high of 5.4. A fresh gain in building sector expectations, which nonetheless stays well below their post-unification and thus 25-year high of November 2015, overcompensated a modest downward correction of the assessment of current conditions. A longer-term comparison underlines the degree of recent outperformance versus the annual averages of 2011 (-6.8) and 2012 (-5.4), let alone the average of the 19-year period 1992–2010 (-29.0) that was linked to a long-lasting correction to the post-unification boom. Extremely low interest rate levels are continuing to support at present, which also explains the strong increase in building permits for housing in 2011 (21.7% year on year (y/y), 2012 (4.8%), 2013 (12.9%), 2014 (5.4%), and 2015 (8.3%). In fact, building permits have been boasting y/y rates around 30% since November 2015, posting 30.6% in the YTD until May.
Finally, the retailer climate rebounded from 8.0 to 10.2, staying only moderately below May's 11.1 that had been the second-highest level of the past five years. Overall, if one abstracts from the second half of 2015 and a phase between mid-2010 and mid-2011, retailer sentiment is near its best levels since the reunification euphoria of 1990/91. This is due to persistently favourable real income developments. Indeed, expectations slipped only modestly and hardly changed in July, in keeping with a sideways tendency since late 2015, whereas current conditions continue to zigzag.
Cyclical position in manufacturing sector returns to boom territory
The Ifo graph on the cyclical position in the manufacturing sector, which sets the diffusion indices of the current situation and expectation components against each other, signals that manufacturing activity narrowly remained in the boom quadrant. Thus current conditions increased further from 18.2 to 19.2 while expectations deteriorated from 3.8 to 0.8 (albeit staying in positive territory). At 0.8 in July, expectations remain well above the mid-point between their historic high of 26.6 in November 2010 and their record low of -52.6 in December 2008 after the Lehman shock. Current conditions are in still better shape, as the latest level of 19.2 remains much closer to its historic peak of 44.0 in December 2006 than to the all-time low of -53.5 in May 2009.
Historically, this indicator of the manufacturing sector's cyclical position has been switching between the boom and the downswing quadrant since May 2010, without ever entering the recession quadrant in-between. Recent developments have thus not been comparable to the recession of 2008–09, which had been so sharp because the depth of the financial market crisis had caught everybody by surprise. The Ifo graph also illustrates that cyclical developments have clearly dominated structural influences in recent years, unlike the situation between mid-2004 and September 2005, when the index remained little changed near the centre of the graph and thus showed a dominance of (restraining) structural factors. German growth has historically depended strongly on global demand, so that the magnitude and sustained nature of any recovery in this field remains important for the extent and duration of Germany’s current upswing. In this cycle, however, unusually robust domestic consumer demand is providing for a degree of resilience that did not exist in the past.
Outlook and implications
Overall, the July Ifo business climate report demonstrates greater-than-expected resilience to the uncertainty spike caused by the UK decision to leave the EU. Indeed, keeping in mind that Germany’s current economic upswing is more domestically rather than externally driven (construction, private consumption, equipment spending), the concurrent increase in service-sector expectations bodes well for the Germany’s overall economic outlook. Even the damage done to manufacturing sector climate has been quite limited. This is likely due to the long transition phase (at least until end-2018) before the UK’s trade relationship with the EU actually changes, and German firms apparently still hope that most of the UK’s access to the common market will be preserved in the end. Meanwhile, the near-term impact of the refugee crisis on the economy will remain positive, as government consumption is being raised currently (enabled by budget surpluses).
The July IHS Markit forecasts for (calendar-adjusted) GDP growth in 2016 and 2017 have been reduced from 1.9% to 1.6% and from 2.0% to 1.4%, respectively, following 1.4% in 2015. In light of the latest leading indicator evidence from Ifo, PMI, and ZEW data in recent days, it appears that the downward revision to the forecast has been somewhat overdone. German consumer demand will in any case continue to be supported in the coming months by high nominal and – given near-zero inflation – real wage growth, ongoing employment gains, and extremely low interest rates that discourage saving.
In the medium- and long-term, we maintain – for reasons related to demographics, fiscal consolidation needs, and still outstanding structural reforms – that average annual growth will remain below 2%. We expect that Germany’s rate of potential GDP growth, which had temporarily improved from about 1.25% to nearly 1.75% during the past decade, will even stay below 1.50% from about 2025 onwards – although recent refugee developments suggest that risks are now biased to the upside.