Germany's economic resilience is crumbling, fueling fears of a recession and increasing pressure on the government to deliver a fiscal stimulus package.
Economic data released Wednesday revealed that the German economy shrank by 0.1% in the second quarter of 2019, having grown by 0.4% in the first quarter. Manufacturers and the construction sector bore the brunt of a global slowdown amplified domestically by trade conflicts and Brexit uncertainty.
The shrinkage in GDP (gross domestic product) growth marks the end of a decade of expansion for the German economy, which has grown by an average of 0.5% quarter-on-quarter every quarter since the end of the 2008/9 recession, expanding in 35 of the last 40 quarters.
However, since the third quarter of 2018, the economy has been in de facto stagnation, with quarterly GDP growth averaging 0%.
In a note on Wednesday, ING Chief German Economist Carsten Brzeski said that while the industry slowdown is not particularly new, recent developments indicate that "the resilience of the domestic economy to external shocks is crumbling."
"Profit warnings, first lay-offs, an increase in short-time work schemes, falling consumer confidence and weaker activity in the service sector have sounded the alarm bells," Brzeski said.
Trade conflicts, Brexit uncertainty and global geopolitical crises, along with an ailing automotive sector, have all taken their toll. The German economy ministry said in its monthly report on Wednesday that the outlook "remains subdued for the time being."
"Trade conflicts have recently worsened and the prospects for an orderly Brexit have not improved," the report added.
Brzeski suggested that the weakening of the domestic economy is the most worrisome trend facing Germany, rather than wider economic stagnation.
Barclays vice president of macro research, Iaroslav Shelepko, also said that Wednesday's GDP print confirmed the vulnerability of the German economy to external demand slowdown, amid heightened uncertainty over trade.
German industrial output posted a quarterly decline of 1.9%, its steepest quarter-on-quarter fall since the last technical recession observed amid the euro area debt crisis in 2012/13. However, Shelepko suggested that domestic demand has thus far demonstrated "remarkable resilience" due to the services sector offsetting much of Germany's trade-related industrial weakness.
"Looking into Q3, the labor market will be key to watch for any emerging cracks amid the ongoing industrial recession," Shelepko said.
"Disposable income growth and private consumption resilience might be at risk should the downturn in the industrial sector spread into services."
Combined with continued external challenges, such as persistent trade-related weakness in global demand and elevated geopolitical uncertainty, Barclays expects the German economy to post another mild decline in the third quarter of 2019, therefore entering a technical recession even before Brexit and the risks to U.S.-EU trade are due to crystallize.
Brzeski said Germany needs a "two-pillar stimulus package" comprising a short-term stimulus and an increase in the "long-run growth potential."
This stimulus will have to go beyond state measures such as "bank bailouts, scrapping and short-time working" which were successful in 2008/9 because the economy was fundamentally sound, and must instead address structural problems.
"The buzzwords are well-known: digitization, climate protection, energy transition, infrastructure and education," Brzeski added.
He highlighted growing support to agree on climate change measures in September, to increase investment in digitization, and to reduce the so-called solidarity tax as indicators of long-term reform.
The solidarity tax, a government-imposed tax levied in a bid to fund theoretically unifying projects, was introduced at a flat rate of 7.5% on all personal income after the reunion of East and West Germany in 1991.
Brzeski also suggested that there is ample fiscal room for maneuver.
"The government's interest payments have dropped from 2.7% of GDP in 2008 to some 0.8% of GDP this year," he said.
"The government could run fiscal deficits of some 1.5% of GDP and the debt-to-GDP ratio would still stabilize at 60%."
While running deficits instead of surpluses is currently "still more than one bridge too far" for the German government, some fiscal loosening looks "more likely than many might think," he concluded. Without this, the outlook for the German economy will be beholden to external factors.