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Blog Posts — July 19, 2019

Weak economy, strong markets? – The German recession anomaly

by Christoph Schon, CFA, CIPM

Despite a steady stream of bad economic news, European stock markets just posted their best half-year performance in almost 10 years. The disconnect is most notable in Germany, where the DAX® benchmark showed a year-to-date return of over 17%, even though all important economic indicators have been pointing toward a contraction for more than 6 months. This discrepancy between financial markets and the “real” economy has, in our view, been driven by the anticipation of monetary policy expansion, in particular from the US Federal Reserve Bank. The notion is further underpinned by the recent co-movement stock and bond prices, as share prices rose, while bond yields were depressed by decreasing interest-rate expectations.

Key indicators point toward a contraction

All major leading indicators for the German economy have been in contraction territory since at least the beginning of the year. The Ifo Institute’s overall business climate index, for example, posted its worst value since November 2014, descending to 97.4 in the month of June. This was the sixth consecutive reading below 100—an area that implies unfavorable business conditions. The forward-looking expectations component has been pointing downward for even longer, after falling into contractionary territory in October 2018. Likewise, purchasing manager indices have been painting a bleak picture for a similar length of time, as did the ZEW indicator of economic sentiment, which is based on a survey of 300+ financial market experts. The bleak outlook was also confirmed by actual industrial production and orders data, which both sank by far more in the month of May than most analysts had predicted.

All eyes on the Fed

So, what fueled this robust stock market performance? The answer lies, in our opinion, on the other side of the Atlantic. Since the Federal Reserve Bank changed its monetary policy stance to neutral at the end of last year and now even expansionary, American blue-chip stock indices have gained more than 28%, breaking record high after record high. The notion that the next interest step will be downward is now so deeply ingrained in market expectations that even the recent stronger-than-anticipated consumer price growth had almost no impact on short-dated Treasury yields.

Euro sovereigns a safe haven for risk-averse investors

With European stock markets firmly in thrall of their American counterparts, Eurozone sovereign bond yields were the safe haven of choice for risk-averse investors. Since the start of the year, the 10-year German Bund rate—which is seen as the safest investment in Europe and, therefore, the benchmark for euro-denominated debt markets—has declined by half a percentage point to around -0.3%. This means that investors are now effectively paying the German government for the opportunity of lending it their money. Only the Swiss Confederation can command a higher “fee” of 0.50% for that same privilege.

When I started my career as a fixed-income analyst almost 20 years ago, I was taught that the price of the Bund Future can never go above 160 (10 annual coupons of 6% plus the nominal of 100%, discounted at a zero-interest rate). Nowadays it is trading well-above 170.

The return of the doves

One might expect economic reality to one day catch up with the exuberant stock markets. Yet, the recent dovish central bank rhetoric seems to lend a lot of support to overall market sentiment and share prices continue their ascent. This is even more probable now that European Central Bank President Mario Draghi has raised the prospect of resuming the bank’s bond-buying program, if inflation remains persistently below its 2% target level. The nomination of International Monetary Director Christine Lagarde as a possible successor to Draghi, who is due to step down at the end of October, is perceived as a sign that the accommodative stance will continue.

Still, with key indicators continuing to point toward contraction, industrial orders and production data surprising on the downside, and with governments and thinktanks constantly lowering their growth forecasts, it is difficult to avoid the feeling that all this is not going to end well.