Column-German relapse trolls European ‘soft landing’: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – Even as U.S. markets are reasonably buoyed by hopes of a “soft landing,” a new recession in Europe’s biggest economy is raising more serious questions on the eastern side of the Atlantic.

The weakness of German industry may not come as much of a surprise to anyone who has been paying attention. The past two years have featured Ukraine-related energy shocks, intensifying Chinese competition in the auto sector, a crackdown on electric vehicles and a painful loan.

For ING economist Carsten Brzeski, watching German macro data is “like a long walk down the boulevard of broken dreams.”

But even by the standards of the past two years, the latest news is alarming.

Although Germany’s economy showed tentative signs of recovery earlier this year, the country’s September business surveys point to a relapse. This is largely due to the stumbling of China, Germany’s biggest trading partner and with which it traded a quarter of a trillion euros worth of imports and exports last year.

Germany’s manufacturing sector appears to be in deep contraction again, according to both the S&P Global reading and the Ifo survey.

The S&P Global Index, which combines both the manufacturing and services sectors, suffered its deepest decline in seven months in September. The Ifo manufacturing index fell to its lowest point since the June 2020 COVID-19 pandemic lockdown.

Germany’s leading economic institutes are now set to cut their forecasts for 2024 to show a 0.1% drop in gross domestic product, which would mark a second consecutive annual contraction.

This kind of shallow recession may not yet be a “hard landing” per se – and Germany’s eurozone partners are doing better. But it shakes confidence in anything that could be defined as a “soft” touch.

The European Central Bank is offering help, with two interest rate cuts already in place this year.

But its moves have been in smaller clips than the jumbo cut unloaded by the Federal Reserve last week, and the pace of further cuts appears to be fidgeting in Frankfurt’s Eurotower.

POLITICAL FOOTBALL

Despite the business issue, you’d be hard-pressed to find much uneasiness in the German market’s core values.

Top German stocks hit record highs last week. And even if it doesn’t help struggling German exporters, the euro is near its best levels in two years against the dollar – with the real effective exchange rate index near its highest in a decade.

Where you’re more likely to see “hard landing” concerns reflected is in rising credit spreads – or risk premiums – for high-yield bonds. While so-called junk bonds benefit from interest rate cuts, the impact is modest compared to the hit they typically take from weak earnings and recession-fueled default fears.

But – like their US equivalents – euro “junk” bond spreads are close to their narrowest since the invasion of Ukraine and ECB tightening since early 2022.

The elephant in the room is the automotive sector – estimated to account for around 7% of the European Union’s GDP, and even more in Germany.

As BlackRock’s (NYSE: ) credit team pointed out, the sector represents about 6% of the Bloomberg Pan-European Investment Grade Index and nearly 11% of its high-yield equivalent. And tough yields make it among the worst-performing sectors both this month and the current quarter.

JPMorgan’s European credit team earlier this month said it was underweight cars for the full year, citing “significant headwinds” from lower-cost Chinese rivals and energy concerns.

And it was another tough month for Germany’s “champions,” with Volkswagen’s (ETR: ) unprecedented plan to close factories on its home soil and a BMW (ETR: ) profit warning sending its share price tumbling.

Both companies blamed a combination of Chinese competition and rising labor and energy costs in an industry that is clearly hurting more broadly. The Autos and Parts stock index has underperformed the broader market by about 15% this year.

As JPMorgan’s team notes: “The sector has become one of the main political footballs in the developing global trade war.”

China’s latest stimulus measures this week could change the demand picture a bit, and German auto shares rose on Tuesday.

But with the US election looming and tariff wars escalating and protectionism now a constant threat, it seems unlikely that the hold on German industry will dissipate anytime soon.

It’s hard to see how Germany stops spraying – whether it can be limited to just cars is a bigger question.

The opinions expressed here are those of the author, columnist at Reuters.

(By Mike Dolan; Editing by Paul Simao)