German Ifo business climate expectations decline in January to weakest level since 2012 reinforces case for economic slowdown

 Frankfurt/Main (26.1.19) – In January, the headline Ifo business climate index reflecting conditions in industry, services, trade, and construction has declined for the fifth consecutive month, slipping from 101.0 to a 35-month low of 99.1. Although it should be noted that this still exceeds the long-term (2005-2018) average of 97.6, it appears that the ongoing headwinds from external developments (especially US protectionism and Brexit concerns) are increasingly taking their toll and causing a more pronounced economic slowdown than previously anticipated. The Ifo institute comment on the latest data by stating that “the German economy is experiencing a downturn”. That being said, one needs to keep in mind that the Ifo index had shown much less of a deterioration during 2018 than other key leading indicators such as the purchasing managers’ index (PMI) and the ZEW survey and therefore overstated actual growth developments as we now know. In that sense the Ifo business climate index is now better aligned with the other indicators and with the hard evidence on economic activity. This argues against getting overly pessimistic on growth prospects in 2019.

Pessimists will point to January’s particularly sharp decline of the expectations component from 97.3 to a six-year low of 94.2 that also now clearly undercuts its 98.3 long-term (2005-2018) average. It needs to be considered, however, that this component is also more vulnerable to general sentiment in the media, which has been quite negative about economic prospects for a number of months now. By contrast, firms’ assessment of current conditions is more closely tied to their own hard numbers about output and demand, and this component has slipped only slightly from 104.9 (revised up from 104.7) to 104.3. This is not only still closer to its series high of 109.1 in February 2018 than its long-term average of 96.9, but it also remains above any level observed during 2005-16. Although the expectations component by nature tends to lead the current conditions index within the business cycle, the negative gap between the two has never been as large as at present. This raises the possibility that the expectations component is driven to a larger extent than in previous cycles by herd behaviour rather than by firms actually seeing a dramatic drop in orders in their business area.

The latter suspicion is reinforced by the January breakdown by sector. Deterioration was seen across the board, and – with the sole exception of the construction sector – it was driven almost exclusively by expectations. Indeed, current conditions even improved in the wholesale and retail sectors and in services, and they worsened only modestly in manufacturing to a historically still quite elevated level (higher than anything observed between the start of the current series in 2005 and March 2017). Meanwhile, the construction sector climate had been at or near all-time highs in recent months and was presumably impacted negatively by relatively severe winter conditions in January (compared to the past few years). The Ifo institute say that the climate deteriorated in all major industrial branches but the chemical sector – the latter was likely helped by the normalization of river transport of commodities as water levels rose significantly. Ifo also point out that capacity utilization in manufacturing, while slipping by 0.7 points to 86.3%, still clearly exceeds its long-term average of 83.7%.

Overall, the additional dip displayed by the Ifo business climate survey in January does strengthen the case for a more pronounced or at least lengthier economic slowdown than previously believed. At the same time, the persistently high level of the current conditions component indicates that the resilience of the German economy to dampening factors from abroad remains considerable. For much of 2018, the Ifo survey had overstated the health of the economy (unlike the PMI and ZEW surveys), but the declines of recent months have reduced or even eliminated this gap now. As such, caution is advised in terms of extrapolating these recent declines to Germany’s economic prospects in the coming months, as there could easily be a phase now in which leading indicators understate actual business activity on the ground. It must not be forgotten that the special factors that hurt GDP growth during most of the second half of 2018 (the new emission standards in the auto sector and low river water levels) are unwinding right now in early 2019. Furthermore, the significant boost to consumer purchasing power due to much lower fuel and heating oil prices since about mid-December can be expected to boost consumer demand now. Global uncertainty tends to be a dampening factor for exports and investment, but German consumers are much more concerned about domestic inflation than anything else. Given last year’s above-average wage and pension increases and persistently good labour market conditions, consumer spending should thus remain a key pillar of the economy. Finally, looking beyond weather influences, the construction sector will remain at historically high activity levels in any case given structural support from demographics, pent-up demand, and still very low interest rates.

The mid-January IHS Markit forecasts for (calendar-adjusted) GDP growth were 1.5% for 2018 and 1.4% for 2019. The latest monthly frequency data and the evidence from today’s January Ifo report suggest that the prediction for 2019 needs to be reduced, albeit only moderately so to 1.2%. Growth in the first quarter of 2019 remains likely to be near 0.6% q/q and thus well above the underlying trend of only 0.2-0.3% because of the unwinding of the above-mentioned special factors and additional effects from the fiscal loosening measures becoming effective at the start of 2019. In any case, with Germany’s public sector boasting a budget surplus of 1.7% of GDP in 2018, the government could easily afford to implement additional measures to prop up demand in case the economy weakens sharply further, e.g. in case of a chaotic no-deal Brexit.

 Best regards, Timo Klein