The New Year’s rally on Wall Street and global markets ran into turbulence during January. Rising virus cases and more stringent lockdowns, a shaky rollout of the vaccine in the US and Europe and the emergence of more virulent strains tempered optimism about the recovery. A frenzy in select stocks prompted a surge in anxiety and volatility on Wall Street. But the equity market bounced back into February, supported by still intact recovery expectations and a calming in market volatility. The uptrend in bond yields sputtered amid myriad developments and uncertainties, only to resume as stocks rebounded.
Fundamentals were briefly pushed to the side in the final week of January, as a frenzy erupted around shares of GameStop and AMC that was driven by retail investors taking cues from internet message boards. However, a rise in margin requirements and curbs on trading activity calmed trading in those high profile shares, easing the market’s anxiety.
The vaccine rollout was a bit rougher than hoped in the US and Europe during January, with reports circulating of unused doses and challenges with distribution. Moreover, the emergence of mutated strains globally prompted worries that the vaccines may not be as effective against the new strains, delaying a return to normal activities. Moderna and Pfizer reported that based on laboratory studies, their vaccines are only effective against one of the new variants. The mutations are an evolving situation that the markets will follow closely in February, even as vaccine distribution ramps up globally.
But as February began, encouraging signs emerged on vaccine distribution, infection rates and hospitalizations in the US and Europe. Consequently, global recovery expectations have been rolled ahead, not reduced or eliminated.
In the Eurozone, the Q4 GDP growth wasn’t as bad as feared. However, the risk of a double dip recession in both the Eurozone and the UK remains firmly on the table, as services in particular continue to suffer. Inflation has jumped higher at the start of the year, especially in Germany, which backs expectations that neither the ECB, nor the Bank of England are likely to add additional rate cuts. Eurozone Q4 GDP contracted -0.7% (q/q, sa), less than initially expected in the light of renewed lockdowns towards the end of the year. Economic activity was down -5.1% in the last quarter of 2020, compared to a year earlier, highlighting that there is a long way to go before activity has reached pre-pandemic levels even if restrictions are lifted quickly, which is unlikely to be the case. Hence, the risk of a technical recession remains firmly on the table, while data also highlights the growing divergence between Eurozone countries, which will pose a challenge for politicians and central bankers alike going forward.
Germany’s economy seems to have weathered the pandemic better than many other Eurozone countries, largely thanks to a resilient manufacturing sector, which has remained open during the current lockdown, and the recovery in major export markets. Like elsewhere, the central scenario remains for a recovery in activity in the second half of the year. But looking ahead, it will be key that the government doesn’t go back to the pre-pandemic status quo, but focuses on a structural renewal that helps to lift long term growth potential. The fact that Chancellor Merkel will leave the political stage following the general election in the second half of the year may be the chance to achieve just that.
German economic activity contracted -5.0% last year, somewhat less than feared, although adjusted for calendar effects the contraction was somewhat higher at -5.3% y/y. Of course Covid-19 developments and lockdowns are largely to blame, with much of the weakness concentrated in the first half of 2020, when strict lockdowns brought activity to a standstill.
Activity picked up over the summer, before another wave of infections resulted in the current lockdown. While this lockdown is less strict than in some other European countries, the hospitality and travel industries remain effectively shut down without the prospect of a swift easing of restrictions. Vaccination programs have started, but remain in the state hands, which has led to a very uneven rollout. Still, the manufacturing sector remains largely open and construction actually managed to expand last year. Furthermore, stock building exercises ahead of Brexit helped to boost manufacturing in Q4. However, there will likely be demand missed in the first quarter of this year and the chances are that there will be a technical recession over Q4 2020 and Q1 2021.
Still, the main scenario is for a recovery in the second half of the year, also helped by very favourable financing conditions and fiscal support that was scaled up substantially in 2020. The overall debt to GDP ratio is still much lower than in many other Eurozone countries, and with government bond yields negative out to the 10-year area and the ECB continuing to buy substantial amounts in the secondary market, clearly Germany doesn’t have a real problem financing the debt, especially with a huge current account surplus.
A healthy fiscal situation already helped Germany to scale up wage support programs and job retention schemes at the start of the pandemic and the jobless number has remained low by comparison — falling to just 6.1% at the end of last year. Like elsewhere it will take time before the true impact on the labour market will become clear — once government support has been phased out. The risk is that the pandemic will lead to higher structural unemployment if and when there are major structural shifts, with the older generation likely to struggle to re-integrate into a changed labour market.
Indeed, the pandemic has highlighted fundamental problems in Germany’s economic model. Like in other countries, the challenge for the government will be to use the funds being made available now to facilitate a shift in focus and a structural renewal. Economically that requires a move away from the focus on manufacturing and a strengthening of the still woefully inadequate digital infrastructure. The success of BioNTech in the search for a vaccine highlighted that there is still life in Germany’s R&D sector, but the overall number of start ups has been quite low in recent years compared to other countries. Germany will need to focus on promoting structural renewal — the exit of Chancellor Merkel from the political stage and the end of a focus on budget consolidation should provide the perfect opportunity for that.
Chancellor Merkel, who has been in office since 2005, really is on the way out now. She already relinquished the party leadership at the end of 2018, and will likely leave the political stage at the general election in the second half of the year. The experienced leader still helped to guide Germany through the pandemic. Her background in science clearly was beneficial during the first wave of the pandemic, when a swift reaction to developments prevented the type of death numbers seen elsewhere in Europe. Ironically though, that actually backfired to a certain extent as the lack of cases and excess deaths early on played into the hands of conspiracy theorists denying the existence of a real virus threat, leaving Chancellor Merkel with state premiers that not only went further in re-opening the economy over the summer than Merkel would have liked but also delayed the reaction to the renewed rise in case numbers later in the year.
There already have been coalitions between the conservatives and the former protest party at the state level, but whether this is a viable option for Berlin will also depend on who will become the candidate for Merkel’s succession in the general election. Merkel’s CDU is currently busy trying to determine a new party leader, and business-man Merz seems to have the upper hand. Under Merz, the CDU is likely to move more to the right and a pre-Merkel type of conservativism that would make cooperation with the Green Party more difficult. On the other hand, it may help the CDU/CSU win back some of the voters that went over to the AfD in protest against Merkel’s immigration policy. As such it could help to de-fragment the German political landscape.
If Merz becomes first party leader and then Chancellor, it would likely also have a positive impact on the digitalisation and the start up culture in Germany. However, Merkel’s departure is also likely to leave its mark on the political landscape in Europe and will have wider implications for the Eurozone and the EU going forward. A shift towards a greater focus on business interests under Merz will likely also mean an attempt to push German interests at European level and ultimately greater confrontation with the southern block. For now the focus on the pandemic has helped to gloss over differences at the ECB, but with the end of the pandemic, internal discussions and conflict are likely to pick up. Ultimately that could be healthy and if it does undermine market confidence in the Eurozone for a while and thus weigh on the EUR, that may actually be a welcome development at least at the start of the recovery.
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