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Investment insights from Capital Group

In spite of intensifying concerns around deindustrialization, German manufacturing is quickly adapting to a new economic paradigm. In the short term, it will likely see continued pressure on energy-intensive sectors, but in the medium to longer term, there are encouraging signs that German industry can establish itself in low-carbon technologies.  

As the world rapidly digitizes and the automotive industry embraces electric cars, Germany risks falling further behind countries such as China that have developed their technological capabilities. On a comparative basis, Germany’s labour costs exceed other manufacturing regions. Adding to its struggles is stagnant labour productivity as Germany’s aging population retires or shifts to part-time work. This trend doesn’t bode well given Germany’s historic strength producing leading-edge automobiles and dominating the manufacture of equipment, chemicals and pharmaceuticals.  

Germany was the only Group of Seven (G7) member to post negative growth in 2023, and some fear a prolonged period of stagnation. Yet, green shoots still sprout as the economy attempts both near- and long-term structural shifts. 

Does a sharp drop in manufacturing spell trouble for Germany?  

Monthly industrial production figures from the Bundesbank revealed a sharp drop in manufacturing output to cap 2023. Consumer durables posted particularly weak output, falling 5% in the fourth quarter of 2023 and 11% year over year. Tighter financial conditions and the uncertainty around the health of China’s economy are impediments forcing industry to adapt.

A look under the hood of the data shows the economy is moving to higher value-added manufacturing

Despite Germany’s woes, monthly data could be overstating the weakness in manufacturing activity. Quarterly estimates of gross value added (GVA) suggest manufacturing activity was more resilient in 2023, which may reflect a boost relative to production or may signal German firms have shifted to higher-value products within industries. GVA is the value for the amount of goods produced, excluding input and material costs.

On a cyclical basis, the industrial downturn may be close to an end

While the cyclical downturn has had a broad impact, manufacturing has been hurt less than other sectors, including construction and retail, according to the Munich-based Institute for Economic Research (Ifo). Taking a step back, Germany’s manufacturing sector isn’t nearly as weak as it was in 2008 or 2009, nor in 2020 during the COVID-19 pandemic. The Ifo’s most recent business climate survey revealed a rise in March, with less pessimism expressed by companies. Still, there are signs that inventories are now at more comfortable levels so that any increase in orders could feed through to higher output over the next six to nine months.

Exporters face vulnerability due to their reliance on China 

Germany’s exports could soon face headwinds from lingering high interest rates along with an economic slowdown in China. German companies are curtailing reliance on China, but they still rely on Chinese imports for production, creating another barrier to a quick economic turnaround. China also boosted its own exports to other nations, creating global competition for German companies that sell goods abroad.

Germany’s trade-to-GDP ratio is over 80%, which is well above other major European economies (typically around 50% to 60%) and the United States and China (around 20% to 30%). This exemplifies Germany’s sensitivity and reliance on global trade. Meanwhile, German manufacturing GVA still accounts for 20% of the total German economy, compared to about 10% in the U.S., United Kingdom and France.

Automobiles, particularly electric vehicles (EVs), illustrate Germany’s fight to maintain its historic industrial reign. Chinese automakers, including BYD, compete technologically and at lower cost. In response, the EU Commission launched an anti-subsidy investigation against Chinese EV makers last year. The investigation continues and could result in some modest duties applied by the EU, which in turn could spark retaliation by China. While this could help its automakers catch up on EVs, Germany remains highly exposed to commerce with China and should avoid a caustic trade spat.

The economy and society are learning to adapt

Fortunately, Germany appears to have avoided energy shocks from the Russia-Ukraine war. Germany had previously imported over 50% of its natural gas from Russia. Manufacturing output declined by much less than was feared, and GVA rose by 0.25% last year. Germany has been able to source gas from areas such as Norway and the Netherlands, while also developing its own liquefied natural gas infrastructure.  

The country’s shift to clean energy, Energiewende, has faced hurdles, but it has also been an area of innovation. Germany has become the leading G7 nation in low-carbon technologies as a share of GDP, signaling its progress in newer industries such as battery products and aspects of solar manufacturing, including photovoltaic components. 

Germany has also gained ground in trade with the eurozone, the U.S. and other parts of the world. Prior to the COVID-19 pandemic, its exports to China rose to a record high but have since retreated following the lingering constraints the pandemic placed on supply chains.

A vibrant Germany is necessary for Europe’s long-term health 

The terms-of-trade shock induced by the pandemic and the Russia-Ukraine war appear to have abated. This should alleviate some of the pressure on Germany and the broader EU. With this, lower inflationary pressure should improve the nation‘s real incomes this year. 

Undoubtedly, Germany’s economic contribution is vital to the EU, especially as Europe seeks to quell concerns around weaker growth. Technological innovation, trade and a firm geopolitical presence are all necessary for the EU to prosper. To regain its industrial dominance, Germany must have the freedom to maneuver with new trading partners.