The German Economic Rifle Shoots Back 10 years later

The central mistake most investors make when it comes to Germany can put triple-digit gains in your pocket

The Big Story

Frank Lungen runs an employment agency in Rosslau, a quaint old Eastern German town located near the confluence of the Mulde and Elbe Rivers. At the start of 2006, Herr Lungen’s company had roughly 500 job openings on the books. By the end of the year they had over 1,000 jobs to fill.

Times are good in Rosslau these days: as evidenced by Lungen’s books, there are plenty of good positions available, with more coming every day, and not enough good people to go around. But it wasn’t always like this. As recently as 2005, Germany was the fabled “sick man” of Europe, plagued with high unemployment and sluggish domestic demand.

During the late 1980’s and early 1990’s Germany’s annual GDP growth rate averaged over 4.5%. Then 1993 came and they caught an eleven-year economic cold; the annual GDP growth rate averaged a meager 1.2%.

It wasn’t until 2004 that things started to turn around. What happened during those 11 years? Why did the German economy fail so miserably after unification? Why is it rocketing back now? And perhaps most important, how can we grab a piece of the action without airlifting dollars to Berlin?

East vs. West

It’s a well-accepted truism that the East German and West German economies were as different as apples and oranges. There were certainly some obvious variations in both politics and mood, what with the Bundesrepublik Deutschland operating west as a moderately socialist democracy and the eastern Deutsche Demokratische Republik installing a repressive “worker’s regime” obsessed with controlling every gritty detail of personal life.

In the end, the west’s post-war rebirth – its Wirtschaftswunder – saw the massive destruction wrought by World War II morph into the world’s fourth largest economy, a veritable model for “eurosuccess.” And the poor souls stuck on the east side of the Wall? They emulated their Russian brothers-in-bondage’s adage: “We pretend to pay and you pretend to work.”

But beyond issues of politics, morals and even style, there lurked a dangerous similarity. At the moment of unification, both economies were concentrated on industrial production, especially machine tools, chemicals, and automobiles powered by a reasonably well-trained labor force and feeding product out of country via a modern export system.

Wiedervereinigung

Commencing in August 23, 1989, when communist Hungary removed its border restrictions with Austria, the physical barriers between these two opposed camps fell one by one. On October 3rd, 1990, the Deutsch Wiedervereinigung was complete, with the two Germanys becoming a united political entity, and the two economies supposedly melded into one single unit.

It was the first time in history that a capitalist economy and a socialist economy had merged literally overnight. As there is no guidebook on how to do this, a number of problems cropped up, the most severe being the comparatively poor productivity of the former east’s economy, and its lingering links to the collapsing socialist economies of the Soviet Union and Eastern Europe.

With the loss of its command labor force, eastern German production costs shot up. Conversion rates of the East German Mark to the German Mark often kept those costs high, as did the early wage negotiations, which resulted in wages far above the productivity level.

This inadequate infrastructure became a problem for many potential investors. Telephone service was improved, but very slowly. Investors complained about energy shortages, as many eastern power stations were shut down for safety and other reasons. Roads and railways had to be virtually rebuilt because they had been so badly maintained pre-reunification.

Financial Angst

All this geldverlegenheit – this financial embarrassment – caused the eastern economy to slip into a deep recession during the first phase of unification. During 1992, the number of unemployed reached a record number, 4 million.

Two-thirds were unemployed in western Germany; the other one-third were unemployed in eastern Germany. At this point eastern Germany was contributing more to unemployment than to production.

The 1992 depression continued into 1993, and the economy registered a growth rate of -1.2 %. By 1994, the German Central Bundesbank’s lowering of short-term interest rates had finally started to shed some light, German growth stabilized at an annual rate of about 2.4%.

This stabilization however was over shadowed by unemployment, which increased despite the uptrend in GDP growth. It was expected that the stronger growth would begin reducing the numbers of unemployed by 1995. Unfortunately, that was not the case. The absorption of eastern Germany, and the methods by which it had been accomplished, had exacted a high price throughout all of Germany well into the late 1990’s and early 2000’s.

The Comeback Kid

Over the last couple of years Germany has experienced what some might call a “Rocky Balboa Moment” (or perhaps Wladimir Klitschko?). GDP grew by 3% in 2006, the fastest rate since 2000.

When the economy was at its lowest, in 2002 and 2003, exports kept Germany’s head above water. They are still strong in the manufacturing/exports department, but it seems that domestic demand, mainly investment, has been the catalyst for the recent economic surge.

Construction also turned a corner, after being a growth killer for over a decade. Even consumers are opening their wallets again. The retailer’s federation reported that shop revenues in Germany have increased after falling for 13 straight years.

Moreover, the International Labor Organization reported that Germany’s unemployment rate was at 6.4% in April, down from 8.12% just a couple months before. This is well below France’s 8.1% and not so far above England’s 5.5%.

As the third largest economy in the world behind only the US and Japan, Germany maintains practical if not titular control over most of the EU’s currency decisions, allowing it to drive polices that have allowed the Euro to handily trump the US dollar in value, suggested to some that it may become the global currency of choice in the very future.

This has offered Germany an extremely powerful position in purchasing negotiations for the raw commodities its industrial base requires. However, this may in the long run act as a brake on exports. That labor shortage we mentioned could is also and inflationary stimulant. Additionally, while Germany’s purchasing power is impressive, it is slowing falling behind the curve when it comes keeping up with the massive growth in energy costs.

This familiar boom/drag conundrum can be quantified to one of our usual “offside-hedged” option plays. First we must choose a proxy for the market as a whole. Since this is a macroeconomic play, it makes sense to choose an index or ETF rather than attempt to isolate the perfectly typical German stock.

In this case, the iShares MSCI Germany Index (EWG) counts 10 of the top German blue chips as components, including more than a few familiar names like Mercedes, Siemens, Bayer and Deutsche Telecom. Fortunately, this ETF has a high beta correlation to the action on the German bourses. Additionally, options against the EWG are traded here in the States, eliminating the need to move capital through the foreign exchanges.

The Play

The primary component of your offside hedge should be two EWG April 34 calls (EWG DH), currently available for $320 per contract, with a delta of 0.65.

Should the EWG move to $38.01, the value of two contracts would move from $640 to $1,017, a gain of 65%.

Should the EWG attain its longer-term target of $40.10 that bundle of two contracts would be worth $1,328, a gain of 107%.

If you wish to factor out volatility, you should purchase a single EWG April 32 put contract available for $170.

Cheers,

Jack Aubrey
Senior Equity Analyst, Residual Income Report