German economy at risk
With a full-blown energy crisis on its hands, Germany’s outlook is dire: So far in this year, expectations for 2022 GDP growth have been downgraded from 4.10% to 1.50%, and 2023 estimates have plummeted from 2.35% to 0.40%.1 Unfortunately, we see further downside risk to growth, upside risk to inflation, and expect German equities to remain under pressure as forward earnings expectations are revised down to reflect lower GDP estimates. We highlight the growing list of cyclical and structural headwinds to Germany’s economy.
- Consumer and business confidence—The ZEW Index for economic expectations is in deeply negative territory, at its lowest level since 1992. Ifo Business expectations are at levels only seen during the Global Financial Crisis and the COVID-19 pandemic. The former typically leads industrial production (IP), so IP forecasts for 2022 and 2023 continue to see downgrades.
- Inflation—Producer Price Index (PPI) measures continue to far surpass expectations and grow at an elevated rate. The last measure of PPI increased 37.2% year over year.
- Import prices—Weakening terms of trade given the rising price of imports don’t bode well for the economy: Energy costs are front and center here. Export volumes and prices have also increased, but not nearly at the same pace.
- Global demand—Germany is vulnerable to declining global demand given that exports to China and the United States make up approximately 3% and 4% of German GDP, respectively.
- Dependence on Russia—German dependence on Russian energy is among the highest globally. Consequently, the country is at the mercy of any potential weaponization of natural resources.
- Industry—Germany risks losing its industrial edge as energy rationing would force factories to limit production. Comments by corporations in Germany hinted at relocation if necessary (although this is more easily said than done).
- Corporations on the edge—Corporate bailouts have already begun for systemically important companies, including US$15 billion for utilities firm Uniper, Germany’s largest importer of Russian gas.
- Deglobalization—This is a threat to Germany’ trade-dependent and open economy, as is resource nationalism, a growing global theme where governments and citizens assert control over natural resources located in their territory. Germany relies heavily on imports for raw materials: The DAX has a zero weighting in energy and basic materials.
ESG factors are driving the current macroenvironment
Despite environmental, social, and governance (ESG) investing taking a back seat to recession fears in investors’ eyes, ESG factors have quietly been a critical driver of the global macroenvironment this year. We list some prime examples:
Underinvestment in fossil fuels has led to a severe supply shortage of traditional sources of energy, but while supply is challenged by the environmental factor, governance has also played a role in energy inflation this year. Sanctions against Russian energy have exacerbated the European energy crisis, and geopolitical dynamics with Iran have driven prices for crude and natural gas even higher. Ironically, the obvious solution to this problem—reverting back to accessible but dirtier energy generation such as coal—is hampered by environmental concerns: With global warming lowering water levels, major transport routes such as the Rhine River have made the movement of materials even more challenging.
Similar to energy, both environmental and governance factors are driving a large amount of the supply-and-demand imbalance of foodstuffs. Global warming has created severe weather events: Droughts in Brazil and the United States, heat waves in India and China, and flooding in Pakistan have damaged key crops. The war in Ukraine has also weighed on both crop and fertilized production. As geopolitical tensions rise, we see the theme of resource nationalism gaining prominence, which will put upward pressures on food inflation as economies introduce protectionist measures to secure their food supply.
The painful inflation dynamic that stems from these factors ultimately puts pressure on growth as households’ purchasing power and corporate profits decline. While ESG analysis for bottom-up equity and fixed income is well understood, a top-down, multi-asset approach to ESG factors is a newer phenomenon—but is becoming an increasingly important factor in cross-asset returns.
How forward looking are forward earnings?
As our core view of a sizable global growth slowdown has materialized, it leaves us questioning when forward earnings will start to retreat from such lofty levels. A series of our forward-looking indicators—including PMIs, new orders, and housing data—suggests that negative equity revisions are in the cards.
But recent work we’ve done suggests that in prior recessionary periods, S&P 500 Index forward-looking earnings per share (EPS) has peaked, on average, just 42 days before the official start of the recession.
Equity analysts typically haven’t gotten bearish on individual securities until right before recessions—and in the case of the Global Financial Crisis, 31 days after the recession was declared; similarly, forward EPS has typically troughed, on average, 135 days after the recession ended. Furthermore, the maximum EPS drawdown averaged 28%. We note that a limitation of this study is that forward earnings are nominal and therefore not adjusted for inflation. Current levels of elevated inflation are flattering earnings expectations, which could allow them to appear higher for longer.
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