• There was more bad news on the German economy this morning with weaker PMIs and a downward revision to Q3 GDP. The economy has contracted by 0.7% over the past two years and now the clear threat of Trump tariffs looms large. Even if these prove to be limited in scope, we worry about second-round effects of weaker confidence on the labour market.
• So what’s the good news here? There are various tailwinds which could support growth over coming quarters: 1) more sustained household spending driven by recovering real wages, 2) a new government bringing about stronger policy direction and moderate fiscal stimulus, 3) the ECB’s continued easing cycle, and 4) a near-term boost to trade as firms try to get ahead of any rise in tariffs. Any Ukraine-Russia peace settlement would also be supportive.
• Our base scenario is for 0.5% growth in 2025, a weak figure but an improvement on the likely contraction across 2024. We see risks as slightly more balanced than a focus on tariffs would suggest.

More bad news on the German economy

There has been a range of bad news on the German economy this morning. The flash PMIs for November were weak with the composite figure slipping from 48.7 to 47.3, a nine-month low. That was led by a sharp fall in the services component (manufacturing sentiment actually improved, marginally). It’s not exactly a surprise to see weak confidence numbers after the announcement of a snap election and the possibility of Trump tariffs (see below).

German Q3 growth was also revised down to 0.1% Q/Q from the preliminary estimate of 0.2%, tempering any optimism created by the initial upside surprise (see here). Longer-term, it’s still a bleak picture. The German economy has contracted by 0.7% over the past two years, with growth over recent quarters essentially fluctuating around zero. We see negative annual average growth again in 2024 (-0.1%).

We still see scope for a limited rebound ahead

Despite this we still look for a return to positive growth in 2025 (MUFG: 0.5%) with some support from various factors. While there was a downward revision to the overall Q3 GDP number, the expenditure breakdown was mildly encouraging. Net trade was the main drag on growth, albeit a substantial one with a 1.9% Q/Q fall in exports, but there was a healthy 0.3% Q/Q increase in consumer spending. Government consumption also increased, by 0.4% on the quarter.

Chart 1: German growth has hovered around zero

Chart 2: Sentiment weakened in November

We see scope for household spending growth to be sustained into next year. Real wages increased by around 2.5% Y/Y in Q3 with pay continuing to recover from the 2021-22 inflationary shock. The growth impact has so far been limited by higher savings rates (Chart 4), but we expect this trend will stabilise or possibly reverse as the pandemic/energy shocks become more distant and interest rates continue to fall.

On the ECB outlook, we have pencilled in a terminal rate of 2% next year, from 3.25% currently. Lower rates will provide some good news for the capital-intensive manufacturing sector and may boost confidence more broadly. On the fiscal side, we expect some increase in government expenditure following the election with a focus on defence and wider investment, while greater stability and policy direction would also be positive (more on this below).

We also believe that there may actually be a tailwind from trade around the turn of the year as US manufacturers and wholesalers look to get ahead of any increase in protectionism. The new orders component of the PMI was the main driver of the overall improvement in the manufacturing PMI today and is something to watch closely over coming months.

Chart 3: Real wages are now recovering…

Chart 4: …but households have increased saving rates

Trump tariffs remain the clear downside risk

How much will these factors offset the drag from any change in US trade policy and related uncertainty? It is of course unclear to what extent Trump’s campaign rhetoric will translate into actual policy, but we believe the EU will be high on any target list for tariffs given its widening trade surplus with the US. Our current base scenario is that the US will impose some targeted tariff measures on various EU goods (and that the EU will quickly respond in a proportionate manner).

The German economy would be most exposed to US tariffs, but the static impact of select tariffs on GDP would still be relatively limited in such a scenario. However, the threat of escalation and higher tariffs, as well as heightened uncertainty around potential geopolitical flashpoints, would remain in sharp focus for Germany’s open, trade-intensive economy.

There’s clear scope for significant second-round effects on German manufacturing. The industrial sector has struggled under a range of structural issues (e.g. increased competition from China in the EV sector, relatively high energy costs, low availability of skilled workers). Production is around 15% below the 2017 peak and these long-term pressures are set to remain.

There are particular risks for the labour market, which has actually been somewhat resilient during the extended slump in manufacturing. The unemployment rate stands at 6.1%, an increase of only 1pp on the pre-pandemic rate. With difficulties in recruiting appropriately skilled workers we suspect that German manufacturing firms have avoided making redundancies in the hope that demand conditions will eventually turn around. Trump tariffs could be the trigger for firms to push ahead with lay-offs, and in turn that could tip the German economy into a more serious slowdown.

More positively, Trump has also said that he could swiftly broker an end to the Russia-Ukraine conflict. The German economy would stand to benefit from any peace settlement through a broad decrease in geopolitical uncertainty as well as private sector involvement in Ukraine’s reconstruction, and the perhaps cheaper energy costs. But the details would matter – any deal would need to be credible and durable for these benefits to be felt. It is plausible that any deal may collapse and ultimately embolden Russia further, resulting in an even stronger drag on manufacturing and consumer confidence.

Chart 5: Manufacturing employment has been relatively resilient to the extended slump in output

Chart 6: Economic policy uncertainty has been especially elevated in Germany since the start of the Ukraine conflict

The snap election may be net positive for the outlook

On domestic politics, our view is that the early timing of the next election is net positive. Current polling suggests that a CDU-led ‘grand coalition’ with the SPD is perhaps most likely. The current governing coalition broke down amid disagreements over the 2025 budget but has long lacked direction after being hamstrung by infighting. Given the exposure of long-term structural issues, especially in industry, the resulting policy vacuum has been suboptimal. A functioning government and increased political stability would clearly be positive in that regard. (But to be clear, this is not guaranteed – it is plausible that a three-party coalition would be required again for a majority, which could be inherently unstable and fractious, and/or the government formation process could be slow).

A new government with a mandate would also offer the opportunity for a policy reset and stronger leadership. In terms of growth, any fiscal loosening would support the medium-term growth outlook. The election could result in some relaxation of the debt brake (which, in a significant remark, the CDU leader Merz has said could be “discussed”) or use of special funds. That could pave the way for more active industrial support, or higher infrastructure and defence spending. Our base case is more fiscal stimulus following the election but we would stress that any radical rethink of Germany’s fiscal leeway seems unlikely under a CDU-led government.

Chart 7: A CDU-led government is most likely following a slump in support for current coalition partners

Chart 8: There is clear scope for an expansion of fiscal support

Outlook – Weak growth, but growth nonetheless

While there is a clear sense of gloom around the German economy right now, we see the outlook as more mixed than a focus on recent survey data, GDP figures and Trump tariffs might suggest. We do think weaker sentiment and fears about greater protectionism will drag on activity. But there are also various tailwinds which could support growth over coming quarters: 1) more sustained household spending driven by recovering real wages, 2) a new government bringing about stronger policy direction and moderate fiscal stimulus, 3) the ECB’s continued easing cycle, and 4) a near-term boost to trade as firms try to get ahead of any rise in tariffs. Any Ukraine-Russia peace settlement would also be supportive.  

Our base scenario is 0.5% growth in 2025. In the context of the German’s economy extended period of stagnation (which puts two consecutive years of contraction mildly) and ongoing challenges, such a low figure would still represent a welcome uptick in activity. To be clear, risks are tilted to the downside given the heightened possibility of tariffs being added to the mix of long-term challenges for industry, but there are a range of factors which could plausibly work in the opposite direction.