German Ifo business climate data stage remarkable broad-based rebound led by expectations in September

In September, the headline Ifo business climate index reflecting conditions in industry, construction, and wholesale and retail trade recovered in remarkable fashion, rebounding from 106.3 to a 28-month high of 109.5. The July/August post-Brexit declines have thus been fully recouped, the September level even exceeding that of June’s interim high by 0.8 points. It also exceeds the long-term average of 101.7 by a large margin. Historic extremes are a low of 83.7 in March 2009 in the wake of the Lehman collapse and an all-time peak of 114.3 in November/December 2010. The strong September data is broadly in line with latest manufacturing PMI developments. The Ifo institute comment on the latest data by saying that the German business world “expects a golden autumn”, having spoken of the cycle having “fallen into a summer hole” only one month ago.

The expectations component of the Ifo business climate survey increased sharply from 100.1 to 104.5. The increment of 4.4 points was last exceeded in mid-2009 when the German economy emerged rapidly from the post-Lehman recession, and the only other instance during the past 26 years that expectations improved this much in a single month was an outlier in February 2002. The level of 104.5 only just falls short of the November 2015 interim high of 104.6 and is otherwise the highest since May 2014. It is also now well above its long-term average of 100.3 again. Meanwhile, current conditions did not improve as much as expectations, but they also increased markedly from 112.9 to 114.7, almost matching July’s 27-month high of 114.8 and widening the gap with its long-term average of 103.3. It should be kept in mind that even the latest downward correction of some length (during April–October 2014) only extended to 108.3, never even getting close to its long-term average. The all-time record of 121.9 seen in June 2011 should nonetheless not be at risk in the foreseeable future due to the high levels of international political uncertainty at present (including the Brexit, the unstable situation in the Middle East and Turkey, and the looming US elections).

The separate Ifo survey release about the climate in the service sector – a series available since January 2005 – signals an extension of the rebound observed since June, having temporarily shown a downward tendency during the first five months of 2016. The headline indicator improved from 29.8 to 32.2, thus newly approaching the all-time high of 34.7 of December 2015. September’s increase was driven by both current conditions and expectations. The former recovered further from 37.8 to 39.9, while expectations posted their fourth increase in succession from 22.0 to an 10-month high of 24.7. The latter is no longer far from the all-time peak of 26.2 of November 2015, contrasting sharply with an interim low of 13.3 recorded as recently as May. Current conditions, which had deteriorated by a much more limited amount in early 2016 (from 45.4 in December to 37.1 in March), have accordingly rebounded in a more restrained fashion in recent months. In any case, expectations and current conditions remain well above their long-term averages of 11.2 and 23.8, respectively. The bigger picture reveals that the overall service-sector index initially unwound the break-out to the upside observed in the second half of 2015 during Q1 2016, but has now recovered anew. During the almost 12-year history of this service sector series, expectations have fluctuated between -25.6 (December 2008) and 26.2 (November 2015), and current conditions between -12.1 (May 2009) and 45.4 (December 2015).

Breakdown reveals improvements across all sectors, current conditions and expectations both benefit

The breakdown of the main Ifo survey by sector, relating to goods production and trade, reveals that all sectors posted large increases based on improvements in both current conditions and expectations. Manufacturing led the way, boosted by a huge spike in expectations back to late 2015 interim highs. The construction sector established a new post-unification all-time high, in this case driven the most by improving current conditions. The climate gain among retailers also benefited the most from rebounding current conditions (rendering this sub-index consistent with the favourable real income background again), whereas wholesalers displayed a large rebound in expectations that fully recouped the previous month’s sharp dip.

The details show that business climate in the manufacturing sector jumped from 6.4 to 13.3, its highest level since May 2015. The Ifo institute did not comment on export performance, but a statement confirming that the business climate improved in almost all manufacturing branches implies that the mood among exporters brightened too. Exports will thus hardly become a drag on the economy in the coming months.

The construction sector climate improved from 5.6 to a new post-unification all-time high of 9.1. Building sector expectations are now back at late 2015 interim highs, and the assessment of current conditions is posting one record after another. 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, which also explains the strong increase in building permits for housing in 2011 (21.7% year on year), 2012 (4.8%), 2013 (12.9%), 2014 (5.4%), and 2015 (8.3%). In fact, building permits have been boasting year on year rates around 30% since November 2015, posting 26.1% in the year to date until July.

The index for wholesale trade rebounded from 5.7 to 11.6, essentially recouping the previous month’s decline and approaching once more June’s interim high of 15.2. September’s recovery was mostly driven by expectations, but current conditions also contributed.

Finally, the climate in retailing similarly rebounded from a near-two-year low of 2.5 to 7.9. This upward correction had been expected in view of persistently favourable labour market and real income developments.

Cyclical position in manufacturing sector returns to boom territory with a vengeance

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 has returned squarely into the boom quadrant. Current conditions increased from 16.3 to 18.9 and expectations importantly rebounded sharply from -3.0 to 7.8. Expectations are thus much closer to their historic high of 26.6 (November 2010) than their record low of -52.8 (December 2008) after the Lehman shock. Current conditions remain in very good shape, the latest level of 18.9 comparing to an historic peak of 44.0 in December 2006 and an all-time low of -53.4 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 September Ifo business climate report puts all notions of a slowing German economy during the second half of 2016 to rest. The knee-jerk downward correction triggered by the Brexit vote has been overcome three months on, not least due to the realisation that any major changes in the UK’s trade relationship with the EU will not occur before 2019 or even later. This corroborates the encouraging evidence from manufacturing PMI data recently. By contrast, the similarly encouraging evidence of the services part of the Ifo survey in August/September is at odds with the large decline in that period of the headline business activity index of the service-sector PMI survey. Given the overall improvement regarding industry, construction, wholesale, and retail trade, it seems most likely that service-sector PMI will recover shortly. Germany’s current economic upswing is more domestically driven than in past cycles (owing to construction, private consumption, and equipment spending), but exports now look to be less of a drag than might have been thought recently. Meanwhile, the near-term impact of the refugee crisis on the economy will remain positive, as government consumption and investment is being raised, enabled by budget surpluses.

The September IHS Markit forecasts for (calendar-adjusted) GDP growth in 2016 and 2017 were kept at 1.8% and 1.7%, respectively, having been raised in August from July’s 1.6% and 1.4% when the near-term Brexit impact turned out to be less severe than initially feared. Today’s Ifo data suggests that the anticipated acceleration of growth in the final quarter of 2016 will push average growth next year closer to the 2% level, whereas the average of 2016 will be impacted only slightly.

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.