Don't Hold Out For A Lasting German Economic Rebound

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Includes: EWG, GERJ
by: The Wilder View

German industry is plugging away. Ending in August, the 3-month average of the seasonally- and calendar-day adjusted volume of industrial production (excluding construction) maintained a quick 8.3% annualized pace. Even if this core measure of industrial activity falls another 1% in September, the Q3 quarterly annualized pace would be 10.5% - a robust acceleration from Q2 (6.3%). This suggests that the German economy quickened in Q3 – does that mean it’s all clear for the euro area?

I think not.

According to The Wilder View Leading Economic Indicator (TWV-LEI), the annual pace of German manufacturing is set to slow quickly, if not contract, by the end of this year. (I constructed my own indicator since the OECD indicators are generally lagged by two months.) In September, five of the seven components that drive the index confirm a sharp deterioration in economic activity (the final two indicators have not been released yet). This downward trend in TWV-LEI for Germany has been in play since August 2010 and is yet to be fully reflected in industrial production (IP); that will change.

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(Click to enlarge)

The chart above illustrates The Wilder View’s leading indicator for Germany (TWV-LEI, Germany). TWV-LEI is a composite of the following variables: PMI manufacturing, Ifo business climate index, manufacturing orders, employment opportunities index, inflation expectations, consumer confidence, and the terms of trade. I’ve found that these indices have the highest correlation with current economic activity, which is measured by industrial production. The r^2 of a simple univariate regression of annual industrial production growth on the 5-month ahead leading indicator (annual growth) reveals an 81% correlation – Implied IP is the fitted dynamics of this univariate regression. Unless leading surveys improve dramatically, I expect the German economy to soften much further in coming months.

Using the 1993-2011 time series, the precipitous drop in the TWV-LEI portends a sharp slowdown in German industrial activity, even contraction by December 2011. The implication is that German economic activity, while accelerating in Q3, is likely to contract in Q4.

The policy ramification is clear: It’s going to get a lot more difficult to sell a "comprehensive solution" if the leading euro area economy is in recession.