Amid rising uncertainty surrounding Europe, Moody’s earlier this week lowered its outlook for Germany. Now, given the likelihood that Europe will continue to be a source of economic risk and investor angst, many investors are wondering whether they should stick with German assets. For now, I think the answer is “yes” on German stocks but “no” on bonds.
As the largest economy and paymaster of Europe, Germany is at the center of the European crisis. Despite this, both German equities – up more than 12% year-to-date – and German government bonds have performed well in 2012.
Viewed in isolation, Germany looks to be one of the more resilient developed markets. The German economy grew 3% in 2011, outpacing the United States, and is expected to grow by around 1% in 2012. Inflation is falling, German companies remain world-class exporters, and the return-on-equity (ROE) for German companies remains close to 13%, comfortably above its 10-year average.
The risk of course is what lies right outside German borders. Some investors are worried that Germany will ultimately acquiesce to assuming even more liabilities from the southern European countries. Others worry about an even more disruptive scenario: a euro breakup.
Under the euro-breakup scenario, German bonds would probably appreciate in price and investors will probably be better off with German bonds than German stocks. However, in my view, the more likely scenario is that the euro survives after a prolonged and costly transition toward fiscal union. This process will be painful for both German stocks and bonds – lower growth will hurt stocks and mutualizing the debt of other countries will hurt bonds. However, in my opinion, German stock prices already reflect the pain that further integration will entail while bonds don’t.
In fact, German stocks appear cheap. The DAX Index is yielding roughly 4%, more than twice the level of long-term German government bonds. German stocks sell for 9x forward earnings, as measured by price to earnings (P/E), and roughly 1.1x book value, as measured by price to book (P/B). These valuations compare favorably with those of other developed countries, whose equities trade at more than 14x and more than 1.60x P/B.
German debt, on the other hand, looks expensive. Ten-year bonds are yielding 1.165%, even lower than U.S. Treasuries. As is the case in the United States, the yield on government debt is now well below the current inflation rate. Unless inflation falls sharply in the coming years, investors are accepting a negative real yield for the privilege of loaning to the German government.