Europe’s manufacturing powerhouse is stalling.
In Germany, inflation has slowed. Wages are robust. The labor market is solid. But a deep-seated industrial malaise that few analysts saw coming is spreading through the country. Germany has become the only G-20 economy apart from Argentina’s that the Organization for Economic Co-Operation and Development projects to shrink this year.
How should investors navigate an upside-down world in which a longtime economic growth leader becomes a laggard spiraling into deindustrialization, threatening to drag all of Europe down with it?
The war in Ukraine shattered the foundations of Germany’s longstanding energy partnership with Russia, and the impact of Russia’s retaliatory efforts is now being felt in full.
“It’s now become clear just how much of a hit German industry has taken from that reduced gas consumption,” says Helen Thompson, professor of political economy at the University of Cambridge. “Germany finds itself in a nightmarish position.”
This German nightmare turned even darker with the slowdown of its biggest trading partner—China. Germany’s exports to China represent more than 3% of its GDP.
Germany’s challenges have been wrought by external factors, but they’ve exposed cracks and vulnerabilities in an economic model with deep roots in aging industries like chemicals and auto manufacturing.
Both of those industries are facing existential threats in Germany as chemical companies struggle with high energy costs and traditional car manufacturers face a significant new challenge from electric vehicles.
THE Upside / Downside
GLOBAL ECONOMY
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In a time of
unprecedented DOWNSIDE,
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A lot of things are changing and they’re all changing at the same time, and that is a problem for Germany.
If we don’t adapt, then the ripple effects will be quite significant.”
Sebastiano Ferrante
Head of Europe,
PGIM Real Estate
Manufacturing as share of total economy
Can German Manufacturing Withstand a Perfect Economic Storm?
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Sources: OECD, Bloomberg, 2021
21
%
GERMANY
G7 COUNTRIES
%
14
(excl. Germany)
THE
CHALLENGE
It’s impossible to know when the war in Ukraine will end, and under what terms. But investors can re-evaluate their approaches as they consider the shifting dynamics around it.
When Europe experienced its shale export boom from the US in 2017, Germany doubled down on its relationship with Russia, signing the Nord Stream 2 deal. As a result, when Russia invaded Ukraine and the gas pipeline was plunged into chaos, Germany didn’t have any LNG ports—let alone the ability to source LNG from the US.
Now, with an even bigger differential between industrial gas costs in the US and Germany, Germany is scrambling to fast-track its LNG capacity, constructing new terminals with unprecedented speed—but Thompson says that no matter how many LNG ports Germany can build in short order, German importers must compete with Asian countries for supplies. And this bid for energy independence is happening alongside the transition to sustainable energy.
Sebastiano Ferrante, PGIM Real Estate’s Head of Europe, says that Germany has a tall—perhaps insurmountable—task.
“If you’re speaking to someone from outside Germany, everyone will always assume that Germany is an extremely well-functioning market,” says Ferrante, who is based in Frankfurt. “But some German business leaders are complaining about this, saying, ‘Things are getting more and more inefficient. We’re not able to have trains that run on time. Things have changed. Things are not working as before.’”
Investors must also consider shifts in perspective as Germany’s relationship with China evolves in unpredictable ways. As the US has sought to reduce its economic ties to China and Germany’s own government has encouraged businesses to do the same, German companies already invested in China have in fact increased investment, turning to China as a way to offset the losses from Europe’s escalating energy costs.
For example, two mighty engines of the German economy, the chemical company BASF and Volkswagen, broadened their Chinese investments, directing billions to production sites and partnerships.
“There’s risk that Germany will run into the same geopolitical end as the Russia gas relationship,” says Thompson. “It's a bet that the corporate interests can prevail over the present geopolitical logic of the Sino-American conflict. Maybe it can. Maybe it can't.”
THE
IMPACT
Even with the enormous uncertainty, Ferrante says savvy investors can effectively change their approaches when it comes to Germany.
“This could be very interesting here if prices come down like they're doing on all asset classes,” he says. “It might be an opportunity to buy.”
One area for investors to zero in on is real estate.
“Germany is what Spain was after entering into the global financial crisis, with all that housing oversupply and followed by a huge correction,” he says. “That seems to be happening in Germany, because of this perfect storm coming together and because housing values have risen so much. There might be an opportunity coming purely from distress.”
A prolonged German slowdown would lead to recession across Europe. But Ferrante says it’s possible that Germany can begin to adapt to a more fragmented and greener world by embracing its strengths.
“Structurally speaking, Germany has an interesting opportunity in all sectors,” Ferrante says. “Everything around engineering solutions for a more sustainable, decarbonized world has the potential to be huge. With the measure of government subsidies coming in, I think we’re going to see a push from those companies now developing new solutions, new technologies.”
In other words, there are opportunities for investors who can envision a transformed Germany.
When it comes to the engine of Europe in its moment of reckoning, it’s imperative to picture the possibilities.
THE
TAKEAWAY
This is a puzzling moment in the US. It is a very perilous one for China. That makes this a very uncertain moment not just for the two countries, but the world.”
Senior Fellow,
Brookings Institution
Eswar Prasad
