The largest economy in the eurozone is weakening. The German Dax index has been hit unprecedentedly hard in recent months. The discount that has emerged on equities presents a prime opportunity according to specialists. “The economic situation in Germany is lousy, to say the least, but the stock market looks good.”
An energy crisis is imminent in Germany. The renowned trade surplus became a trade deficit in June. Inflation is dire and consumer confidence is at an all-time low.
The lights are slowly going out, in some cities literally. In an attempt to save the country from an energy crisis next winter, Berlin is stopping the lighting of public buildings and the Lower Saxon city of Hanover has shut off hot water supplies in sports halls and swimming pools.
As a result, the German stock market is one of the worst-performing markets globally this year in euro terms. “The Dax 40 stands at a loss of 14 per cent year-to-date. For US investors, the decline is exacerbated by the weakening euro,” said Hansjörg Pack, manager of German equity strategy at DWS, who is well aware of the country’s macroeconomic malaise.
“Only in Belgium is the level of inflation higher than in Germany. Although we assume that inflation has peaked, there are a lot of reasons to believe that inflation in Germany will remain structurally high in the future. The ECB is behind the times and has realised too late how persistent current inflation is,” said Pack.
The gas crisis
According to DWS, investor sentiment has now moved towards a ‘Dax-bearishness peak’. With a price-to-earnings ratio 40 per cent lower than that of the S&P 500, DWS calculated that share prices take into account a probability of at least 50 per cent of a severe recession in Germany. A fall in earnings per share of 30 per cent or more will result from the energy crisis.
With natural gas flows from Russia to Germany via the Nord Stream 1 pipeline down to just 20 per cent of capacity, the threat of a gas shortage has become significant in recent weeks.
The European Commission estimates that if deliveries fall to 20 percent of capacity, Germany will face shortages that will require significant rationing, with obvious negative consequences for growth there. If Russian gas flows stop completely, the Bundesbank expects that the necessary rationing of gas will lead to a 5 percent drop in German GDP. “Such a decline in GDP is not currently factored into the rates, but our base case is not that negative,” Pack said.
‘The discount that has been created offers opportunities’
“A complete shutdown of Russian natural gas supplies would undoubtedly push the German economy into a brief recession, but we think a lot of progress has already been made in preparing the economy for this scenario,” Pack said.
Fears that the Dax could fall to its historic valuation level of around 1 times its book value (which currently corresponds to an index level of around 9,000) are exaggerated, according to DWS. Pack: “Our unofficial base case is that we will face a mild technical recession in the coming quarters, but everything depends on the size of the gas shortages.”
“We expect a stagflation scenario and that scenario, as well as high inflation, is already factored into the prices. Based on that conviction, you can say that Germany is very cheap at the moment,” said Pack. Investing in growth companies that are reasonably priced is therefore a smart strategy, according to Pack. “We avoid those companies that grow their revenues incredibly fast, regardless of profits.”
“As far as investing in Germany is concerned, it is advisable to look for companies that have pricing power. Second-quarter earnings proved to be relatively good. Only companies with strong pricing power will be able to maintain these profits,” Pack concluded.
Fidelity positive about Germany
Christian von Engelbrechten, manager of German equity funds at Fidelity, also thinks that many headwinds are already priced in. “If we look, for example, at the price/earnings ratio of the German HDAX index (i.e. the combination of DAX, MDAX and TECDAX) on the basis of expected earnings for the coming year, it is currently around 23% below its long-term average. So the market is already taking into account significant reductions in earnings expectations,” he said.
In the event of rationing and especially in the extreme scenario of a complete stop in the flow of gas resulting in a severe recession, there is of course more downside risk: “Cyclical and energy-intensive sectors such as chemicals, steel and cement, along with sectors linked to private consumption, are at greatest risk,” said Engelbrechten, “while sectors such as healthcare and software should be much more resilient.”
Fidelity’s Germany fund has an overweight to sectors such as healthcare, software and technology, while it has a large underweight in the chemicals sector, for example.
The long term looks good
However, there are also positive longer-term implications to consider, Engelbrechten said he believes. “The history of German companies shows their adaptability. For instance, the share of gross exports in GDP from the mid-1990s has roughly doubled over the following two decades. The reduced growth potential that emerged within Germany from time to time prompted companies to seek opportunities outside Germany.”
According to Engelbrechten, investors should be particularly aware that the time frame is often more important than the timing. “While there is no guarantee of future returns, even investors who bought into the German equity market in 2007 at the maximum level of the DAX, i.e. before the market fall during the great financial crisis of 2008-2009, have significant positive returns today,” he noted.
This article was first published on Investment Officer Netherlands.