Why structural change in Germany may impact investors globally

The new macro regime that is currently unfolding is accompanied by major changes in the economic world order. One such development that we’re closely monitoring is the headwinds hitting the German economy, given its importance for European growth and inflation dynamics, as well as the country’s role as a major buyer of global fixed income assets.

For decades, the German economy has been characterised by export-led growth, low inflation, limited consumer spending and fiscal constraint, which drove massive savings surpluses that were invested in foreign assets. Now, shocks such as the Russia/Ukraine war, weaker Chinese demand and growing structural challenges — notably, demographics, deglobalisation and growing competition from China — are undermining the viability of that economic model and hastening a transition to new sources of growth. How Germany handles that transition will have significant implications for global fixed income markets. 

Germany has faced significant challenges to its economic prowess before. The last crisis, post-reunification, delivered the export-led growth model that is now under such strain. Faced with the cost of reunifying the country, Germany looked outward, backed by a consensus among the centrist political parties, to deflate the economy back to competitiveness — a recipe that was subsequently forced upon the rest of Europe. A series of supply reforms reduced the safety net for households and increased the cost of being out of work, with the twin effect of lowering labour costs and increasing households’ propensity for precautionary savings. These measures positioned the German economy for global growth, just as globalisation was accelerating, by competitively providing the capital goods China required. Secure access to cheap Russian energy and excess production capacity in Central and Eastern Europe, along with a weak euro and a benign global geopolitical environment provided the further ingredients for success. In parallel, German governments pursued fiscal constraint — so much so that a deficit limit was enshrined into the Constitution in 2009 — while unemployment was driven down to record lows without any negative implications for the corporate share of national income (Figure 1).

Figure 1

That economic model has been rocked by a series of shocks and structural challenges:

• Chinese and global trade no longer represent the same growth opportunities given the structural trend towards deglobalisation;
• The Ukraine war has put an end to Germany’s access to a cheap and dependable source of energy supplied by Russia; and 
• Germany’s car industry faces a structural threat from Chinese electric vehicle makers.

These shocks, however, are only accelerating a longer-term trend of declining competitiveness. For all its positives, the Germany’s export-led growth model discouraged investment. And even before COVID, the government was starting to unpick many of the country’s labour reforms. The Schröder government’s “Hartz IV” reforms gave way to “Bürgergeld”, raising unemployment benefits and pension payouts, as well as sharp rises in the national minimum wage.

Yet the current crisis is not being met with the same political resolve that we saw in the early 2000s. Political fragmentation and the rise of non-establishment parties is hampering the current coalition government’s willingness and ability to push through renewed supply reforms Instead, policy is increasingly looking inward, with attempts to boost domestic demand with structurally looser fiscal policy and an expanding labour share of GDP. The key question is how the private sector responds to this transition. Essentially, our research suggests two potential outcomes may play out in 2024 and beyond, each with starkly different market implications. 

1. On the road to rebalancing

The benign and most likely outcome is that Germany evolves into a much more balanced economy, with a lower dependence on exports and a shift to fiscally supported domestic demand. That shift started before COVID as domestic demand became a more important driver of growth. 

If Germany is engaged on this path, the make-up of its economy should converge to the average of Europe rather than being a source of deflation. Such a convergence would make the euro area more sustainable and reduce the risk of sovereign fragmentation. Germany would shift from being a source of supply-led disinflation to demand-led inflation. That would put more pressure on the European Central Bank to keep rates higher for longer.

It would also imply a much slower accumulation of savings as household savings rates and the trade surplus would fall. That has implications for global markets — Germany would stop being a major source of cheap capital for the rest of the world. Since the mid-2000s, German investors have increased their holdings of foreign assets by a massive €8 trillion, an acceleration led by building their holdings of global fixed income securities. Under this rebalancing scenario, that flow would dry up, which could have important implications for many fixed income markets. For instance, German investors have significantly increased their market share of US high-yield and investment-grade credit. A reversal in these flows would exacerbate the uptrend in risk premia and contribute to higher long-term rates.

2. Deflation and political instability

A more negative path is that the German transition is partial rather than whole, with today’s heightened uncertainty causing the private sector to double down on saving, which, in combination with weaker exports, could stifle growth and increase the risk of renewed deflation. From that perspective, the persistent weakness in consumer confidence is concerning, as is the recent German Constitutional Court ruling that limits the government’s attempts to circumvent the debt rules. The growing popularity of far-right (AfD) and far left (BSW) parties also increases the risk that Germany travels this path. It isn’t inconceivable that 2024’s regional elections could give these parties sufficient leverage to cause political paralysis at the national level. Combined with structurally weaker exports and a domestic sector that is reluctant to spend, this could create a dangerous cocktail of deflation and political instability for Germany and Europe, at a time when both require political stability. 

To assess the likelihood of the different paths, we're continuing to monitor various developments, but the key ones to watch are:

• Consumer reaction — For instance, we’re closely monitoring near-term signals such as employment surveys and household surveys on saving intentions.
• A better understanding of the fiscal path forward —In the aftermath of the German Constitutional Court ruling, we’re focused on understanding the fiscal ramifications for Germany and the euro area and the extent to which the coalition government will be able to maintain fiscal flexibility in support of defence spending, the climate transition and rebalancing the economy. 
• Political developments — Near-term signals to watch include polls to assess the fortunes of the far-right and far-left parties ahead of regional elections in 2024, but also the ability of the governing coalition to regain the political initiative and forge a consensus on key challenges. Longer term, we will also be keeping a close eye on emerging discussions regarding the removal of the constitutional budget brake, potentially after the next federal elections.

Figure 2