Deutsche Bank : Uncertainty is slowing capital expenditure

Germany Monitor

January 25, 2017

Uncertainty is slowing capital expenditure

Authors

Eric Heymann ([phone]

[e-mail]

Oliver Rakau

[phone]

[e-mail]

Editor

Stefan Schneider

Deutsche Bank AG Deutsche Bank Research Frankfurt am Main Germany

E-mail: [e-mail] Fax: [phone]

www.dbresearch.com

DB Research Management Stefan Schneider

Original in German: January 18, 2017

In view of the pronounced economic and (geo)political uncertainties and the weak starting level, (private-sector) equipment investment in Germany is likely to decrease in 2017 despite a respectable level of capacity utilisation.

The interplay of multiple factors is currently causing a high level of uncertainty: the potentially serious impact on Germany in the event of the uncertainties materialising, the continued high number of simultaneous uncertainties, the complexity of many capital expenditure decisions and the lack of confidence in politicians (and/or their ability to come up with solutions).

We will present several uncertainty indicators based on news, surveys and financial markets data that provide a way of quantifying the uncertainty. The news-based indicator provides clear warning signs, whereas the other indicators support a more positive outlook. However, a combined indicator points to sustained weakness of capital expenditure in the first half of 2017; in recent years, it has shown a high correlation with Germany's spending on capital equipment.

The Brexit decision in summer 2016 creates a whole host of uncertainties for the years ahead. It is unclear how quickly the United Kingdom will leave the EU and what the situation will be afterwards. As the UK is one of Germany's main export markets, the imminent entry into uncharted political territory will probably subdue capital expenditure in both the UK and Germany.

Donald Trump's election as the next US president has raised concerns about setbacks for international free trade. His spending and taxation plans along with the appreciating US dollar may partly offset the uncertainty; the effects are more likely to be felt in Germany in 2018, however.

The list of other international uncertainties is long. The main one to be mentioned for 2017 is the strengthening of extremist political parties in the elections that are due to be held in many major EU countries. The risk of a 'hard landing' in China is another regular subject of discussion in view of the growing level of debt. There are also political uncertainties in Russia and Turkey.

The severe shortage of skilled workers is increasing domestic uncertainty due to lengthy and/or expensive recruitment processes that can quickly detract from the value of the capital expenditure. Changes in the skills and qualifications that employees need to have (digitalisation) and in German politics ('early retirement at 63') are compounding the effect.

The shift in German energy policy is acting as a brake on capital expenditure, particularly for companies with very high energy consumption. Although there are many energy and climate policy targets, there is considerable uncertainty surrounding the political measures and instruments, the economic costs, the consequences for consumers and companies, and technical progress.

Uncertainty has been a common theme running through the global economy and financial markets in recent years. This year is unlikely to bring any relief in this regard. Uncertainty could in fact increase even more, particularly in view of the many elections due to be held in Europe this year in which there is a possibility that anti-EU/anti-euro forces will come to power. The negotiations on the United Kingdom's exit from the EU and US president Trump's (economic) policy agenda also contain many imponderables. These are just the first few items on a long list of uncertainties that affect the economic outlook for 2017.

Capacity utilisation slightly higher than

the long-term average 1

Capacity utilisation in German manufacturing, % 100

90

80

70

60

50

07 08 09 10 11 12 13 14 15 16

Capacity utilization Average since 1992

Source: ifo Institut

Government equipment investment

more important lately 2

Contribution to investment in machinery & equipment, yoy, real, 4Q mov. avg., pp

15

10

5

0

-5

-10

-15

-20

-25

-30

05 05 05 05 05 05 05 05 05 05 05 05 05

Government Private Total

Sources: Federal Statistical Office, Deutsche Bank Research

Uncertainties holding back capital expenditure

Ultimately, any economic subject's decisions are subject to uncertainty. This is true for consumers, companies and politicians alike. In contrast to risk, in which the likelihood of events materializing is presumed to be known, the probability of uncertain events occurring cannot be calculated. An uncertain event can have a positive or negative impact if it occurs. What is critical, however, is the lack of ability to plan.

By contrast, the probability of risks materialising and thus the expected consequences are known so, for example, it is possible to calculate expected values in consumer and capital spending decisions. In reality, of course, it is almost impossible to make such a clear distinction between the two terms. For our purposes, we will therefore widen the definition of risk to include circumstances in which plausible assumptions about the distribution of probability can be made.

The effect of uncertainty on companies' capital expenditure is likely to be particularly pronounced. Reliable forecasts are required, e.g. of future unit sales, due to the long period of time before there is a return on the investment and the high costs of cancelling a capital expenditure project. If the uncertainty is too great, companies may find it attractive to postpone projects, particularly large- scale ones, or to scale them back in order to limit the possible losses. If concerns grow that profit targets will not be met by some way, such projects may even be avoided altogether.

Despite slightly above-average capacity utilisation at the end of 2016, we therefore expect (private-sector) spending on machinery & equipment in Germany to decrease in 2017 - a much more cautious assessment than that of many other forecasters. In contrast, a large portion of consumer spending is accounted for by everyday necessities and can thus be postponed only to a limited extent and we expect limited impact of uncertainty.

Given their current relevance, we will concentrate on macroeconomic and political uncertaintiesbelow. The uncertainties that have been frequently discussed in the last few years include a possible 'hard landing' in China and a collapse of the EU/single currency. Last year, these were joined by Brexit and the bleaker prospects for global free trade. The German economy's strong dependence on global trade, integration in global supply chains and the substantial level of German outward investment make such uncertainties particularly relevant to Germany and German companies.

These macroeconomic uncertainties need to be distinguished from classic corporate investment risk. We define this as, for example, fluctuations in demand over the course of 'normal' economic cycles. Customer preferences may also evolve in an unexpected manner. Technological advances and the political and regulatory environment may influence the development of individual products and sectors. These risks have always existed, and companies are rewarded for taking such risks by the opportunity to generate profits.

Large exporters with many trading relationships 3

Share of exporting companies by number of export destinations, %

90

80

70

60

50

40

30

20

10

0

High level of uncertainty driven by extent and complexity

We are currently seeing multiple factors whose interplay is causing a far higher level of uncertainty than was the case in the years between the fall of the Iron Curtain and the global economic and financial crisis, when the integration of emerging markets and developing countries into global trade created structural growth boost to the global economy.

- In our opinion, the biggest factor is the extentof the potential effects on Germany in the event that current uncertainties materialise. These mainly relate to Germany's most important trading partners and, in some cases, would entail significant structural breaks. The economic consequences of

1-5 6-9 10-19 20 and

more

Number Value

unknown

Trump's presidency in the United States, Germany's largest export market (ranked 1st, January to October 2016), are not yet clear, for example.

However, Trump's pronouncements during the election campaign along with

High proportion of "unknown" due to intra-EU trade, where minimum reporting threshold often not reached. Share in total value of exports very low, though.

Source: Federal Statistical Office

Drop in confidence 4

Share of respondents that trust...., %, EU

60

50

40

30

20

10

2/2004

2/2005

2/2006

2/2007

2/2008

2/2009

2/2010

2/2011

2/2012

2/2013

2/2014

2/2015

2/2016

0

Europäische Union Nationale Regierungen

Source: EU Commission (Eurobaromter 86, 2016)

Citizens believe labour market situation

will deteriorate further 5

Share of respondents, %, EU 80

70

60

50

40

30

20

10

1/2009

2/2009

1/2010

2/2010

1/2011

2/2011

1/2012

2/2012

1/2013

2/2013

1/2014

2/2014

1/2015

2/2015

1/2016

2/2016

0

The worst is still to come

The impacto f crisis on jobs has already reached peak

Don't know

Sources: EU Commission (Eurobaromter 86, 2016)

other factors are clouding the outlook for global free trade. Following the Brexit decision, there is no clarity at all about future trade relations and political cooperation between the EU and the UK (ranked 3rd). Europe's political calendar in 2017 is looking busy, with elections in the Netherlands (ranked 4th), France (ranked 2nd) and Germany. Fringe parties are likely to gain momentum and fears about European unity are growing, not least because voting results showed in 2016 that established forces lost out despite being ahead in the polls. Reliable surveys had previously classified such elections more as risks than uncertainties. Snap elections in the UK, Italy (ranked 6th) and even Spain (ranked 11th) cannot be ruled out. This would mean elections in the six largest economies of the EU. The possible bursting of the real-estate bubble in China (ranked 5th) would have global repercussions.

• Moreover, the numberof uncertainties has risen significantly since the start of the financial and economic crisis in 2008. Although they frequently drop out of the spotlight after a phase of dominating the headlines (e.g. Greece, high sovereign debts in Europe, TARGET2 balances), this does not mean that they have actually disappeared.

• Another important factor is the globalisationthat has occurred over the last few decades; it has significantly compounded the effects of uncertainty because national economic and political shocks and uncertainty ripple out to the rest of the world more quickly. Internationalised supply chains mean that negative effects are quickly felt in countries far away. In addition, companies that export goods are operating in more and more markets at once, which is increasing the complexityof their decisions. For example, 5% of German exporters export to between ten and 19 countries and a further 6% in fact export to more than 20 different countries. These 6% account for 82% of exports. The fast paceat which information is disseminated also makes decision-makers aware of uncertainties sooner.

• The lack of confidencein politicians (and their ability to come up with solutions) is probably also contributing to the reluctance to invest because it increases the negative effects that are expected if uncertainties materialise. According to the Eurobarometer survey conducted regularly by the European Commission, only 36% of EU citizens express confidence in the EU (2008: 50%). Confidence in national governments has also declined, although it was already low before the start of the crisis. Despite the gradual recovery of the European labour market, 45% of those surveyed in mid- 2016 said that the worst was still to come for the labour market, with only 42% believing the opposite was more likely. Although these are surveys of all citizens and not specifically of corporate decision-makers, they do provide at least a hint of how great the uncertainty might still be despite the survey results' recent slight improvement.

Uncertainty: Four indicator types provide clues

Uncertainty above pre-crisis levels 6

One of the defining features of uncertainty is that it is not quantifiable, and nor

are its potential effects. However, there are some indicators that, taken together,

Economic policy uncertainty; Average 2016 relative to 1997-2007 average

Netherlands

Japan India Italy USA

Australia Spain Korea Russia Germany Ireland Europe Canada Brazil France China UK

0 1 2 3 4 5 6 7

Sources: www.PolicyUncertainty.com, Deutsche Bank Research

enable reliable conclusions to be drawn about the effects of the uncertainty on investing activities. We have divided these indicators into four main types on the basis of different data sources and different forms of uncertainty.1

News-based indicators

An index of economic policy uncertainty2 based on an analysis of news articles has been attracting growing attention lately. This is due in no small part to the fact that the uncertainty measured by this index, particularly in Europe, has risen to unprecedented levels in recent months. The highest level was reached in the United Kingdom as a result of the uncertainty surrounding the result of the Brexit referendum and the subsequent outcome of the UK's negotiations with the EU. In June, the month of the referendum, uncertainty was ten times higher than before the crisis.

The combination of Brexit and the start of the election campaign has probably contributed to the sharp rise in uncertainty in Germany, too. In recent months, average uncertainty levels in Germany have been at the same high level last seen in 2012 at the height of the euro crisis and more than twice as high as before the crisis. Since the peak in June/July, global uncertainty has fallen again slightly, but remains far higher than the long-term average. However, the uncertainty measure for the United States has risen only a little in recent months, despite the US election campaign.

Economic policy uncertainty elevated especially in Europe 7

Standardised, 6 months average

800

700

600

500

400

300

200

100

0

97 99 01 03 05 07 09 11 13 15

USA UK China Germany Russia Japan

Sources: "Measuring Economic Policy Uncertainty" by Scott R. Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com, Deutsche Bank Research

News-based uncertainty indicators are compiled by searching through news articles for individual keywords or combinations thereof. Examples include the words uncertainty, economy, regulation, legislation and parliament. The index referred to above compares the number of articles identified in this way with the absolute number of articles published. Such indices can apparently ascertain episodes of increased uncertainty very well. For example, the larger peaks in

1 Macroeconomic uncertainty: What is it, how can we measure it and why does it matter? (2013). Quarterly Bulletin 2013 Q2. Bank of England.http://www.policyuncertainty.com/

2 Measuring Economic Policy Uncertainty (2016). Scott R Baker, Nicholas Bloom, Steven J. Davis. March 10, 2016.