NEW YORK (KWR) August 12, 2010 - The German economy is on the move. Despite the storm clouds from the European Union's (E.U.) sovereign debt troubles in May and June, Berlin's austerity measures and choppy political waters, German business sentiment is improving and economic data points to an ongoing recovery. Indeed, within Europe's major economies, Germany is posting the sharpest revival in growth this year and is set to easily outpace the Euro-zone with real GDP growth that is likely to head over 2.0%. It also poses a sharp contrast to the United States, where growth is slowing, concerns over the fiscal deficit are mounting and job creation is clearly lagging.

What happens in one of the world's major export machines is critical to the Euro-zone and other economies. If Germany is on its way to stronger-than-expected growth there are a number of ramifications, largely positive. The major question, however, is one of sustainability, something that is a key question as we look into the second half of the year and into 2011. We think Germany is likely to experience a little better than 2.0% real GDP for 2010, reflecting a bifurcated E.U. in terms of growth, with Italy and France lagging due to their respective structural challenges. Austerity measures and tight credit conditions also remain a major dampening effect for Spain, Portugal, Greece and much of Eastern Europe.

Recent economic data for Germany indicates that many of the country's strengths are being tapped, in particular its highly productive workforce and strong manufacturing export base. Consider some of the more recent data:

• Germany's seasonally adjusted business activity index rose to 56.5 in July from 54.8 in June though expectations had been for it to remain unchanged. This was the 12th consecutive monthly rise in the service sector output;
• PMI data for July was 61.2, (the highest reading in three months) and up from 58.4 in June;
• The July Composite Output Index, which covers both manufacturing and servicing purchasing managers' indexes or PMIs, was at 59 in July, up from 56.7 in June;
• Official figures showed the German economy expanded by 0.2% in Q1 2010, following growth in Q4 2009.

German exports are booming and employment gains are being made, a situation helped by a substantial drawdown in inventories. Germany's unemployment rate is 7.6%, which places it at almost the pre-crisis level and down from 9.1% in January. In a nod to the months ahead, a number of companies such as Siemens (electronics and engineering), MAN (truck maker) and Daimler (carmaker) are adding worker hours. Most recently BMW indicated that it was looking to employ 1,000 people in Germany to work in research and development. Purchasing and sales have also been earmarked for new employees by the automaker.

Germany's growth is generally good news for the rest of Europe as it helps generate confidence that the continent's economic locomotive is working. Moreover, better confidence in the economic outlook translates into consumer spending (helping stimulate imports) and Germans vacationing in some of the other European economies (Greece, Spain and Portugal) which help their economies rebound. Although we have not reached a strong virtuous cycle, the beginnings could be falling into place, which could upgrade prospects for 2011.

The major issue is sustainability. This is dependent on a number of factors:

• The Asian market has been critical for Germany's export rebound. If China slows at a faster-than-expected pace in the second half of the year, it could jeopardize the robustness of German exports;
• There are concerns within Europe that Germany's success is coming at the expense of other Euro-zone countries, like France and Italy. George Soros recently noted: "By cutting its budget deficit and resisting a rise in wages to compensate for the decline in the purchasing power of the euro, Germany is actually making it more difficult for the other countries to regain competitiveness." The other issue is that the Germans made a number of painful changes to enhance their productivity, including wage constraints, which other countries were more reluctant to push.
• German competitiveness could be eroded when the local work force (who have been restrained in wage demands) start to demand higher wages. German wage growth has been stagnant for much of the last decade, as companies increasingly turned to temporary workers during periods of high demand. What do most Germans think about the recovery? A recent Forsa survey (July 28-29) asked whether people were benefiting from the economic upswing, with 82% of respondents saying no. Of those with a monthly net income of €3,000 and more, 24% said they feel the upswing, while only 9% of those with €1,000 or less noticed an improvement.

Perhaps the view by many Germans that they are not benefiting from the recovery has left the political stage a little more unsettled than it should be. Chancellor Angela Merkel's center-right government has had a difficult year, being forced to support the Greece rescue in the face of considerable public opposition, losing ground in the North Rhine Westphalia (Germany's most populous state) elections in May and struggling with the presidential elections this summer (though her candidate eventually won). The ruling coalition is also very low in opinion polls, with many voters indicating their worry over government debt and the need to cut spending and social assistance.

The German mood is probably much like that in the United States and United Kingdom - conditioned by uncertainty as to what the future will bring. Although the German economy is demonstrating a surprising degree of strength, there remains a nagging doubt that it will not last and this feeds into disgruntlement with the standing government, as well as worry about sustainability.

We are left with an economic landscape that is promising in the short-term. The challenge ahead is sustainability, which is dependent on what happens both within Germany and outside. Above all else, Germany is a trading nation; slow global growth can kill trade, Germany's current trajectory is not going to fly as high. Our expectation is that growth slows in the second half of 2011 and in 2012, which could point to slower exports, setting limits as to the German recovery. Most likely it is this feedback into German society and politics that is detracting from the current shift to stronger growth. Germany's rebound cannot be denied, but the real test is going to be whether it can be sustained in the face of global headwinds.