Column: German Relapse Weighs on European ‘Soft Landing’ – Mike Dolan, Reuters

By Mike Dolan

LONDON – While U.S. markets remain optimistic about a potential "soft landing," concerns are resurfacing regarding the economic situation in Europe, particularly in Germany.

The struggles of the German industrial sector have been evident for some time, with challenges stemming from Ukraine-related energy disruptions, increased competition from China in the automotive industry, difficulties transitioning to electric vehicles, and a tightening of borrowing conditions.

According to Carsten Brzeski, an economist at ING, tracking German economic data feels like "a long stroll on the boulevard of broken dreams." However, the latest developments are particularly concerning.

Earlier this year, there were early signs of recovery in Germany’s economy, but recent business surveys indicate a setback. This downturn is primarily influenced by economic issues in China, Germany’s largest trading partner, with whom the country exchanged approximately €250 billion in trade last year.

Currently, Germany’s manufacturing sector is facing significant contraction once again, as indicated by both S&P Global’s metrics and the Ifo survey. The composite index from S&P Global, which includes both manufacturing and services, experienced its steepest decline in seven months this September. Meanwhile, Ifo’s manufacturing index has dropped to its lowest level since the initial COVID-19 lockdowns in June 2020.

Leading economic institutes in Germany are expected to downgrade their full-year 2024 projections, forecasting a 0.1% contraction in gross domestic product for a second consecutive year. While this modest recession might not qualify as a "hard landing," it certainly undermines confidence in any prospect of a "soft" recovery.

The European Central Bank has attempted to provide some support, having implemented two interest rate cuts this year. However, the reductions have been smaller in scale than the more substantial cuts enacted by the Federal Reserve recently, and there appears to be hesitation in Frankfurt regarding future rate adjustments.

Despite these economic challenges, major German market indicators do not reflect widespread panic. Blue-chip German stocks reached record heights last week, and the euro is performing well against the dollar, near its highest levels in two years. However, this strength may not bode well for struggling exporters.

A key area of concern is the widening credit spreads on high-yield bonds, which signal increasing risk premiums. While lower interest rates typically benefit these "junk" bonds, they are still vulnerable to losses stemming from declines in earnings and fears of recession-related defaults. Nonetheless, the spreads on European junk bonds are close to their narrowest since the onset of the Ukraine conflict and the ECB’s tightening measures in early 2022.

An important factor is the auto industry, which constitutes about 7% of the EU’s GDP and an even larger share in Germany. The sector, accounting for roughly 6% of the Bloomberg Pan-European Investment Grade debt index and nearly 11% of high-yield bonds, has struggled with dismal returns, making it one of the poorest-performing sectors recently.

JPMorgan’s European credit team has been underweight on the automotive sector, citing significant challenges from more affordable Chinese competitors and energy-related issues. This month has also been particularly tough for German automotive giants, as Volkswagen announced plans to close factories in Germany, and BMW issued a profit warning that caused its stock to plunge. Both companies attributed their difficulties to increasing competition from China along with rising labor and energy costs within a faltering industry. The Autos and Parts share index has trailed the broader market by approximately 15% this year.

As noted by JPMorgan’s analysts, the automotive sector has become a significant political topic amid ongoing global trade tensions. Recent stimulus measures from China may help shift demand slightly, leading to a temporary boost in German auto stocks. However, with approaching U.S. elections and persistent threats from tariff wars and protectionism, it remains uncertain whether the pressures on the German industrial landscape will ease in the near future.

It is increasingly difficult to see how Germany can revitalize its economy, raising broader questions about whether the troubles will remain confined to the automotive sector or expand further.

The views expressed in this article are those of the author.