A 21st Century German Blitzkrieg

In a recent blog post I wrote about Trump moving (abandoning?) away from Ukraine as Europe’s Sputnik moment. Germany and France, the two biggest economies in Europe, no longer believe that the United States can be counted on to defend Europe so it’s now imperative they take far more control of their own destiny and not put Europe’s fate in the hands of the United States. Some would argue that this is what Trump has been wanting to have happen since his first term and Ukraine was just the inflection point to galvanize Europe. I have no interest in opining on the politics, just the potential impact of this shift.

Is it possible that the days of Eurosclerosis may be coming to an end?

This chart shows how far Europe has fallen behind the United States since 2000, particularly in terms of labor productivity. To reverse this relative decline will require a huge change in regulation, deficit paranoia, tax policy, and Europe’s work to live culture as compared to the United States’ live to work way of being. These are not easy to overcome.

Germany has been dealing with a lot of headwinds with contracting construction and manufacturing. One can see that Germany’s construction industry has been in a multi-year slump.

The weakness is also pervasive in Germany’s manufacturing sector.

And while retail sales in the Eurozone have recovered to their pre-Covid growth rate, the level of growth is still quite muted.

Last week, however, there was a shot heard round the world when Germany announced a huge loosening of its fiscal pursestrings, particularly when it comes to defense spending and infrastructure.

Investors were clearly caught off guard as European bonds got massacred over fear of a much greater supply of bonds and presumably a higher growth rate which would push up real rates of return.

German 10-year bond yields spiked by 0.30% which is a huge move when they were only at approximately 2.50%.

With the rise in German rates, the spread between U.S. bond yields and German yields narrowed quite materially. This probably reflects greater German growth prospects.

This chart shows that Germany’s fiscal deficit as a percentage of GDP could be the highest sustained level in the post-war era.

The major beneficiaries of this sea change have been defense companies and banks. One can see from this chart how, over the last three months, European aerospace and defense companies have risen by approximately 35% while their U.S. competitors have dropped by 0.64%. I don’t see how Trump’s statements, actions, and posturing can benefit U.S. defense firms as European governments feel very exposed by relying on components, equipment, and systems from the United States. As a result, there will be a huge push to source these from European firms. The stock market is starting to price this in.

And while the yield curve is still inverted in Germany with 3-month yields higher than 10-year yields, it became less so with the big move in long rates. This helps bank profitability as banks typically borrow based on short-term rates and lend at longer-term rates. In addition, with a much greater need for borrowing in the years ahead and more economic activity, this should improve the profitability of banks.

The Euro has strengthened materially since Germany’s announcement.

Last week was an interesting week from the standpoint of U.S. interest rates. They were whipsawed after Germany’s announcement but settled back down after Friday’s jobs report. These next two charts show how both the 10-year and 5-year yields are hovering a little above and below key psychological levels of 4.25% and 4.00% respectively.

We locked in a five-year loan on February 28th at a 4.01% Treasury. And while yields did go lower intraday on the 3rd, I felt like there would be a battle for a while that would keep the rate close to 4.00% so I felt good about the decision. And even if I turned out to be wrong that still would have been ok as we have three more maturing loans that need to be locked very soon and potentially two more so we still have a lot of rate lock exposure on the table that would benefit from lower rates.

I will sign off with a humorous, but potentially ominous tweet from a German that I think is a good representation of what a sea change that could be happening in Europe. I’m not the only one struck by the power of this tweet as it garnered 7.8 million views.