Germany – Europe’s Lone Star

Germany is the economic colossus of Europe, its leading exporter, one third of the Old World GDP and its monetary anchor. Even though only three per cent of German exports go to Russia, Germany is dependent on Gazprom for one third of its gas imports.

So it was no coincidence that German equities fell 12 per cent in late July and August, three times the fall in the S&P500 or the Swiss SMI index, as Frankfurt was the epicentre of a panic sell off in European shares once the West imposed economic sanctions on Russia.

The German DAX index lost more than 1,000 points as escalating Ukraine-Russia tensions coincided with a plunge in the safe haven German ten year debt yield to 200 year lows at 0.96 per cent, the ZEW economic survey pointed to a slowdown, Portugal’s Banco Espirito Santo and Austria’s Erste Bank made new fault lines in European banking and Italy went into recession.

The swift, brutal slide in German shares is not surprising since the DAX index in Frankfurt is dominated by exporters, such as the Big Three auto companies (Daimler AG, BMW, Volkswagen), industrial conglomerates (Siemens), or highly cyclical chemical, capital goods and even banking colossi.

During bear markets in Europe, investors normally sell cyclical markets like Germany and Sweden and rotate into the lower beta Swiss market, dominated by mega-cap pharmas Novartis and Roche Holdings. This is the reason the DAX Index trades at a lower valuation multiple at 12 times earnings, while the Europe Stoxx 600 index trades at 13.4 times earnings even after the correction.

It is also not prudent to discount the impact of Russian intervention in Ukraine on German economic growth, exports and consumer confidence. Even ECB President Mario Draghi has observed that the new West-Russian geopolitical confrontation has increased recession risk for the European economy.

Germany’s industrial base is vulnerable to the Kremlin’s “gas weapons,” which Putin has not hesitated to use previously to achieve foreign policy objectives in Belarus, Ukraine and Turkmenistan. German companies like Adidas and Siemens are also major investors in Russia and vulnerable to the Kremlin’s retaliatory response to sanctions.

When Adidas cited Russia as a reason for lower earnings growth, its shares plummeted by 20 per cent. Adidas now trades at 14 times earnings while Nike is valued far higher at 22 times earnings. As Ukraine government forces prepare to seize the rebel held city of Donetsk, German Chancellor Merkel fears Russian military intervention, a geopolitical game changer.

Germany accounts for not just one third of Europe’s GDP but also one third of the EU’s exports and foreign investment in Russia.

There is so much fear in German financial markets that the yield on two- year government bonds (Deutsche Bunds) is now negative, meaning investors are now paying the German state to park their surplus funds.

Russia invaded Chechnya, Georgia, Afghanistan, Czechoslovakia and Hungary in the past without igniting World War Three. However, German financial markets have long memories.

If the Bundesbank is obsessed by the Weimar hyperinflation, Germany’s consumers and business elite have not forgotten the Stalinist puppet state in East Berlin where Vladimir Putin once served as a young KGB major. If Russia invades Ukraine, German political and economic interest in the Baltics, Hungary and the Balkans are in deep trouble.

There are pockets of deep value in the German stock market. Daimler AG now trades at 8.4 times forward earnings and a 4.8 per cent forward dividend yield at a time when Mercedes Benz is introducing a new product cycle, the North American truck market is on a roll and management wants to slash 4 billion Euros in costs.

Daimler AG is a deep value buy near 56 to 58 for a 75 Euro target. Adidas is now unjustifiably cheap relative to its peer group, despite its Russian exposure. Both Daimler AG and Adidas benefit from a lower Euro. There is deep value in the Teutonic Fatherland!