Acrophobia or return of realism?

Fear of heights or trend reversal? Today’s ZEW index shows that German investors have lost parts of their earlier optimism. In May, the headline index dropped for the second straight month to 41.9, from 53.3 in April. This was the strongest monthly drop since August last year. At the same time, the current assessment component dropped for the first time since October last year and stands now at 65.7, from 70.2 in April. Despite today’s drop, both components remain far above their historical averages. German investors seem to be a bit confused. The positive trends of the first months of the year have been (partly) reversed over the last four weeks. The euro strengthened by more than 4.5%, oil prices increased by more than 6% and government bond yields have more than quadrupled. Moreover, the German stock market temporarily lost more than 6%, though it has recovered almost all of these losses in recent days. At the same time, the economy has struggled to match the optimism illustrated by buoyant consumers and business confidence indicators. In our view, there are still very few arguments in favour of changing our positive take on the German economy. In fact, even if the external tailwinds have subsided somewhat, they are still there. Just to put latest developments into perspective: compared with their average value of the last 12 months, bond yields are currently still some 20bp lower, the euro some 10% weaker and oil prices almost 30% cheaper. Still sufficient to give the economy a cool breezy boost. Moreover, domestic fundamentals remain sound and particularly consumption should support growth in the coming months. Looking ahead, there are currently three major risks for our optimistic outlook for the German economy: i) the never-ending Greek crisis, which despite latest rumors of some progress could still escalate and is clearly more dangerous and explosive than financial market participants seem to believe; ii) a longer-than-expected period of weakness of the US economy, which could affect German exports both through less demand and a further strengthening of the euro; and iii) a further escalation of what seems to be a new strike culture in Germany. Up to now, the economic impact from several strikes this year should have been very limited. But this could change. In our view, today’s ZEW correction is not the beginning of a trend reversal and no reason to become concerned about the German economy. It is rather a sign of acrophobia and a return of realism.