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2012 DAX Outlook

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Looking Back

Like most other major global equity indices, the German DAX began 2011 in positive fashion. Equity markets were still feeling the benefits of growing investor risk appetite following the U.S. Federal Reserve's announcement of a second major round of quantitative easing. A solid rally began at the end of August 2010 after Ben Bernanke's speech at the Jackson Hole Economic Symposium. It was then that the Fed Chairman made it clear that the U.S. central bank was ready to embark on an additional program of asset purchases designed to drive down bond yields should the economy show further signs of deterioration. By the time of the FOMC's next meeting in November, the only unanswered question was the scale of this intervention.

Unfortunately, by February 2011, investors were becoming more concerned by the growing instability across the Eurozone. Greece and Ireland were already in receipt of bailout packages, while the situation in Portugal was reaching a crisis point. Then in early March, Japan was hit by a devastating earthquake and tsunami. This sent equity markets into a tailspin and knocked more than 8% off the DAX alone over the course of the week. The devastation led to production outages in Japan brought about by the disruption of supply chains. But the subsequent rally was almost as sharp as the preceding sell-off. It felt as if the tragedy in Japan had served a cathartic effect and cleared out weaker players and over-leveraged longs. In April, Portugal finally bowed to the inevitable and asked the EU for help. By this time, a beefed-up European Financial Stability Facility had been agreed in principal, although it wasn't until October that it gained full approval by all Eurozone member governments.

The German index made a high for the year around 7600 in late April and then traded in a relatively narrow channel until the end of July. The Eurozone debt crisis simmered away over the summer as investors began to worry that it was spreading beyond the smaller peripheral countries of Greece, Ireland, and Portugal. However, it was a last-minute fudged deal in early August by U.S. policymakers to raise the country's debt ceiling and the subsequent downgrading of the U.S. credit rating by Standard & Poor's that saw global equity markets sell off sharply into the close of the year. Over the next two months, the DAX fell around 30%, but steadied as investors became increasingly convinced that central bankers would ultimately be forced to intervene and flood the financial markets with additional liquidity.

The Index

The DAX is arguably the most important European stock index. It covers the 30 of the biggest corporations in Germany, which is the largest Eurozone economy. A breakdown of its constituents shows that three automakers (BMW, Daimler, and Volkswagen Group) account for 14% of the index (up from 9% two years ago). Specialty chemical giants BASF and Bayer are close to17%; diversified industrials around 14%, with Siemens alone providing 10.7% of the index. Financial corporations, including banks, insurers, and brokers make up a little over 16% - down from 22% two years ago.

From a trader's perspective, the constituent stocks are extremely liquid and there is tremendous volume in the futures based on the index. This gives the DAX a depth far beyond that of the CAC or the UK's FTSE100 and an intra-day volatility, which makes it especially attractive to short-term traders. Like the FTSE100, the DAX is less a measure of the strength or weakness of the German economy and more a barometer of the global economic climate. Yet, the DAX has recently underperformed relative to both the UK's FTSE100 and the U.S.'s S&P 500. This underperformance is attributable to the ongoing problems within Europe, particularly the Eurozone and concerns over slowing growth in Germany's crucial export markets.

The German Economy

Germany is the fourth largest country globally in terms of GDP - behind the U.S., China, and Japan. It is also the second biggest exporter, overtaken as number one by China around two years ago. In many ways, it now faces the same problem as China − what to do when your export markets shrink?

Germany built its economy on the solid bedrock of a sound fiscal policy and home-grown industry and manufacturing. While it remains the economic powerhouse of the European Union, Germany has had to restructure much of its manufacturing base. German corporations have had to face up to the reality that emerging economies can do much of what they do, but a lot cheaper. Ship building, mobile phone manufacturing, mass-produced clothing, and consumer electronics are all areas of economic activity that have shifted out of Germany over the years to emerging markets where labor and other production costs are cheaper.

Eurozone Concerns

As a condition for abandoning the deutschemark and accepting the single currency, Germans were promised sound money and certainly, the Bundesbank model has had a strong influence on the ECB. The country's experience of hyperinflation in the late 1920s and early 1930s is often cited as the reason for the reluctance for German policymakers to back calls for ECB balance sheet expansion. But the reunification process is fresher in minds and Germans consider the sacrifices that they had to make to incorporate East Germany into their western democracy as evidence of their discipline and sacrifice for the greater European good. No wonder they despair at the profligate behavior of the southern Eurozone members. Despite this, the German economic miracle has preceded, thanks to a competitive euro - something that wouldn't have been possible with a strong Deutschemark. With weaker Eurozone countries enjoying "German-level" interest rates, they could borrow and spend with abandon, helping to give Germany the trade surplus that it still enjoys today. German banks also encouraged weaker countries to employ leverage. German productivity rose; but its currency did not. In 1999, exports accounted for less than 30% of GDP. By 2008, they were 47%.

The Outlook for Growth

At the beginning of the third quarter, Germany's government halved its 2012 growth forecast to 1% from 1.8%. The rate of expansion is slowing as demand for exports falls due to the global slowdown. Industrial output and orders are weakening, and any month-on-month improvement is likely to be temporary. As with China, domestic demand will become increasingly important. Yet, unemployment could still fall, with the 2012 jobless rate expected to average 6.7% from 7% in 2011. Private household disposable income is expected to rise by 2.9% − more than offsetting an estimate of 1.8% inflation. Also, Germans can look forward to the implementation of a tax reform starting in 2013, which is expected to put €6-7 billion back into taxpayers' pockets.

Looking ahead, there is just too much political uncertainty to attempt to make a worthwhile prediction for 2012. Chancellor Merkel is now becoming increasingly unpopular amongst the German voters, as demonstrated by the repeated drubbing that she has experienced in a series of regional elections. Fortunately, she doesn't face the polls herself until 2013. Chancellor Merkel and French President Sarkozy have repeatedly struggled to come up with a solution to the European debt crisis. Yet many analysts believe that ultimately Germany will feel that it has no choice other than to take whatever action is necessary to keep the union together. While the December EU summit has led to a commitment from Eurozone members to pursue tighter fiscal integration, treaty changes were deemed unacceptable by at least two EU members - the UK and Hungary. Sweden and the Czech Republic need to seek their own parliamentary approval.

There is no doubt that German banks have exposure to the European debt crisis. With France's AAA rating under threat thanks to its own banking exposures (and Italy and Spain effectively hamstrung by their own debts and lack of growth), the financial burden for supporting the Eurozone is increasingly falling on Germany. Yet, it is debatable whether Germany is in a strong enough position to help without doing itself considerable damage.

- David Morrison contributed to this article

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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