Research Edge Position: Long Germany (EWG)
Over the last week there were many critical European data points released. Below we’ve revisited the fundamental landscapes of Germany and the UK within the larger direction of the Eurozone in light of these newly reported facts. We have a bullish stance on Germany (currently in our portfolio) and believe that despite improved fundamentals in the UK, the market will continue to underperform its Western European peers.
Eurostat reported that June Eurozone industrial producer prices fell 6.6% annually and increased by 0.3% from the previous month, confirming the present deflationary environment that we’re seeing. The large drop on an annual basis is better understood in the context of last year’s manic energy prices, and while producer prices rose 0.3% on a monthly basis, excluding the energy sector, prices fell 0.1%. We’ve held that both PPI and CPI (which Eurostat recently estimated at -0.6% annually in July) are in aggregate at a relatively comfortable level given the region’s downturn and helped encourage the ECB and BOE to keep rates unchanged at 1% and 0.5% when they met late last week. That said, we are seeing a divergence in the inflationary outlook in Germany and the UK.
Germany was one of the few countries in the Eurozone to report a decline in PPI on a monthly basis at -0.1% in June, (or -4.3% annually) and today released that CPI fell 0.5% in July Y/Y, with consumer prices remaining unchanged at 0.0% from the previous month. In contrast, the UK PPI recorded a 1.0% gain in June over the previous month, and was down 8.5% from the previous year. On the margin June’s inflationary number is just one data point among many macro factors we follow, yet it points to a larger theme we’ve been making: if producers can’t pass on savings to the consumer it’s one less cog to get consumers to spend to ignite growth.
As we measure changes on the margin, for the UK, the sequential uptick in PPI (with an inflationary CPI reading of +1.8% in June) signals that inflation may be getting ahead of growth, whereas Germany is benefitting from imported deflation.
Critical Metrics Improve Across Germany and the UK
Leadership: For the balance of the last year we’ve been vocally long German Chancellor Angela Merkel’s leadership and short UK PM Gordon Brown’s, and it hasn’t disappointed. Not only did Brown and Co. not demonstrate leadership throughout the country’s downturn, they haven’t pretended to proactively manage the economy. Last week furthered this thread, with the BOE increasing its purchasing program by 50 Billion Pounds ($84 Bill.), with the BOE saying that “the recession appears to have been deeper than previously thought”. We believe Mr. Market will continue to choke on this…
Germany, on the other hand, has maintained a sober fiscal policy, prizing low government debt and low (future) taxes. Merkel has combined the early issuance of its cash for clunkers program with support for the all important auto industry vis-à-vis a bridge loan to GM’s Opel division (before seeking a private buyer), all of which has helped to offset significant declines in export levels and order demand.
Industrial Production and Factory Orders: while German industrial output eased 0.1% in June on the month (after surging 4.3% in May), forward-looking Factory orders rose 4.5% in June M/M, according to last week’s release from the German Economics Ministry. Not only did the Factory number far outpaced a forecast of +0.6%, but added to May’s +4.4% upward charge. As we’re still looking for signs of life from an export picture, positive momentum from factory orders and increased demand from China will be critical to move the scales.
Confidence: sentiment continues to improve across the Eurozone, jumping to 76 in July from 73.2 in the previous month. Germany has now recorded months of sequential improvement in both consumer and business confidence, while the UK’s July consumer confidence number shot up to 60, the highest reading in over 14 months. We hold that that sentiment is an important metric to drive market performance and engage consumer spending, yet believe that for the UK there is a disconnect with reality: the country’s compromised financial system pared with rising unemployment should sting sentiment and continue the FTSE’s measly performance, which currently stands at 6.5% YTD.
Retail Sales and Housing Landscape: UK retail sales far outpaced expectations and rose 1.4% in June M/M or +1.8% Y/Y, according to the British Retail Consortium. This is a clear divergence from Eurozone retail sales, which were down 0.2%, and Germany where despite sequential improvement, sales registered -1.8%. For the UK, we believe that growth in retail sales will not be sustainable unless inflation backs off. In the intermediate term we could see it dip down around the 1% level Y/Y.
While there are incremental signs that the housing market may be improving in the UK, with mortgage approvals, (though a third lower than at the start of 2008) reported as reaching a 14 month high in June and Halifax saying that home prices increased 1.1% in July, we see the overall housing bubble and property devaluation in the UK as a serious fundament risk to growth. On the flip side, debt averse Germans largely avoided the housing mess.
Unemployment: interestingly July unemployment in Germany remained stagnant at 8.3%. While we expect this number to push out in the back half of the year and into 2010, the stability of the number (though lagging) for now is bullish. UK unemployment has now reached historic highs. As this number pushes out we expect sentiment to erode.
Purchasing Managers’ Index: bullishly improving across the Eurozone, Germany, and the UK.
Trade Gap: The UK trade gap was released today at 6.5 Billion Pounds ($10.7 Billion) compared with 6.2 Billion pounds in May. This isn’t a huge surprise as the UK is import heavy, however an increasing trade deficit will only further burgeoning government debt levels. The Euro trading around $1.42 continues to be a headwind for German exports, yet the region’s largest exporter continues to register a monthly surplus.
The data points released last week help confirm an improving trend in Europe’s economy. We continue to see a divergence in market performance across economies, based on unique underlying fundamentals, including uncorrelated trends . Eastern Europe has been a great example of extreme positive market performance with glaring negative fundamentals and admittedly we lost money with Italy on the short side for a TRADE, a country we believe has a very bearish fundamental outlook as its balance sheet blows out with increased governmental debt.
We have conviction that a measureable recovery in Europe will not come without the improvement from the region’s big three: Germany, France, and the UK. Already we’re seeing the slack in the demand picture tighten for the larger economies, which will greatly aid the peripheral countries that rely so heavily on the EU for trade.
For the intermediate term TREND, we believe that Germany’s powerful manufacturing capacity remains a primary structural advantage that may propel growth in the final half of the year as the country benefits domestically from imported deflation. We see the UK constrained by its financial leverage and believe that inflation may be getting ahead a growth, a cocktail we don’t want to be long.
As we’re subject to the data, we’ll change as the data does; however at the right price we want to be long Germany and short the UK.