IHS Global: German Ifo business climate index retreats only modestly in July following Brexit decision

 

Frankfurt/Main (25.7.16) – In July, the headline Ifo business climate index reflecting conditions in industry, construction, and wholesale and retail trade retreated from 108.7 to 108.3. This reflects a considered reaction to the UK referendum decision of 23 June to leave the EU and the decline is much milder than had been feared. The level of 108.3 compares to a long-term average of 101.7 and remains close to the interim peak of 109.0 seen in November 2015. Historic extremes are a low of 83.5 in March 2009 in the wake of the Lehman collapse and an all-time peak of 114.3 in November/December 2010. Most of the recent rebound of the Ifo index observed since March thus remains intact, suggesting that near-term German economic growth momentum will not be hurt unduly by Brexit. The Ifo evidence is consistent with a similarly limited decline of the manufacturing PMI leading indicator in July. Indeed, services PMI had even improved this month, and only the ZEW indicator with its traditional sensitivity to financial market developments revealed a major decline.  The Ifo institute comment on the latest data by saying that the German economy is “demonstrating resilience”.

 

Following a four-month rebound by altogether 4.1 points, the expectations component of the Ifo business climate survey slipped from a six-month high of 103.1 to 102.2. This is a surprisingly mild reaction to the Brexit event, which should be fully captured by the July survey given the timing of the referendum. The level of 102.2 still exceeds the long-term average of 100.3. Meanwhile, July’s current conditions component actually increased slightly further from 114.6 to an eleven-month high of 114.7, getting close to the interim peaks of 115.1 in August 2015 and 115.4 in March 2014. The current conditions sub-index thus remains far above its long-term average (103.2), as is also underscored by the fact that the most recent downward correction of some length (during April-October 2014) only extended to 108.2, never even getting close to its long-term average. The all-time record of 121.9 seen in June 2011 is not in danger any time soon, however, especially given the additional uncertainty introduced by political developments lately (Brexit; political instability in Turkey).

 

Today’s separate Ifo survey release about the climate in the service sector – a series available since January 2005 – has increased slightly further from 27.3 to 27.6. This index had declined from an all-time high of 34.5 in December 2015 to an 11-month low of 24.7 in March before recovering partially in subsequent months. In July, there was a sharp dichotomy between a setback to current conditions (from 41.0 to 36.1) and a sizeable further recovery of expectations (from 14.4 to a six-month high of 19.3). The latter had reached an all-time peak of 26.3 in November 2015 before weakening to an interim low of 13.1 in March. Current conditions, which had deteriorated by a much more limited amount in early 2016 (from 44.9 in December to 36.9 in March), are now broadly back at their March level. Expectations and current conditions both remain above their long-term averages of 11.1 and 23.6, respectively. The bigger picture reveals that the overall service-sector index unwound the break-out to the upside observed in the second half of 2015 during Q1 2016, but has now stabilized at levels that exceed most of what was observed between the start of this series in 2005 and 2014. During the eleven years of history of this service sector series, expectations have fluctuated between -25.5 (December 2008) and 26.3 (November 2015), and current conditions between -12.7 (May 2009) and 45.4 (September 2015).

 

Meanwhile, the breakdown of the main Ifo survey by sector, relating to goods production and trade, reveals a split picture. The climate in manufacturing and wholesale trade deteriorated whereas the construction and retail sectors showed improvements. There was no uniform picture with respect to the roles of current conditions and expectations either. Thus worsening sentiment in the manufacturing sector was driven exclusively by expectations (especially in the automobile sector) whereas in the wholesale sector an unwinding of June’s spike in current conditions was to blame. Conversely, July construction sector improvement (to a post-unification all-time high) was propelled by expectations, whereas the retail sector gain was purely down to rebounding current conditions (which have been zigzagging throughout 2016 so far).

 

Overall, the July Ifo business climate report demonstrates greater-than-expected resilience to the uncertainty spike caused by the UK decision to leave the EU. Indeed, keeping in mind that Germany’s current economic upswing is more domestically rather than externally driven (construction, private consumption, equipment spending), the concurrent increase in service-sector expectations bodes well for the Germany’s overall economic outlook. Even the damage done to manufacturing sector climate has been quite limited. This is likely due to the long transition phase (at least until end-2018) before the UK’s trade relationship with the EU actually changes, and German firms apparently still hope that most of the UK’s access to the common market will be preserved in the end. Meanwhile, the near-term impact of the refugee crisis on the economy will remain positive, as government consumption is being raised currently (enabled by budget surpluses).

 

The July IHS forecasts for (calendar-adjusted) GDP growth in 2016 and 2017 have been reduced from 1.9% to 1.6% and from 2.0% to 1.4%, respectively, following 1.4% in 2015. In light of the latest leading indicator evidence from Ifo, PMI, and ZEW data in recent days, it appears that the downward revision to the forecast has been somewhat overdone. German consumer demand will in any case continue to be supported in the coming months by high nominal and – given near-zero inflation – real wage growth, ongoing employment gains, and extremely low interest rates that discourage saving.

 

Timo Klein, Principal Economist | IHS Markit Economics timo.klein@ihsmarkit.com