VW's Scandal Comes at a Bad Time For Germany

The German economy has been nothing if not impressive. In the face of ugly economic circumstances across Europe, this country held fast to fiscal discipline while staying on track with exports. Hence, Germany ran budget surpluses for the last three years and has a cost of capital so low that its bond yields rival that of Japan.

Then, out of nowhere, comes a claim of corporate cheating that rocked iconic Volkswagen, the “People’s Car” company, maker of the famous Beetle.

It’s too early to know the full extent of the fallout from the scandal, but contrary to the happy face their officials put on the state of their nation, the embarrassment from this episode is just the latest punch to land on Germany. Their economic engine is running out of fuel just as they need to provide more power.

500,000 Americans own VW’s that are illegal to drive. These clean-burning diesels spew nitrogen oxides at up to 40 times the proscribed level under normal driving conditions.

VW admitted to installing software that instructs the vehicles to cheat whenever they encounter test conditions (no movement of the steering wheel, no speed registered while the engine revs, etc.). Now they face $18 billion in fines.

That’s bad. But what’s worse is the potential backlash against the company, which is synonymous with the country itself.

Volkswagen employs more than 270,000 people, which doesn’t include all of the suppliers and ancillary support organizations. They own Audi and Porsche. Cars and auto parts represent 20% of all German exports. The company just announced it will stop selling diesel cars in the U.S. immediately.

This doesn’t represent a big number of cars, but what if the negative effect on the brand dramatically reduces sales outside of Germany in the year ahead? That thought should send shivers down the spines of German leaders, particularly since their economic engine appears to be throttling back.

In August, a month before the VW scandal broke, exports fell 5.2%. This was the biggest drop since the financial crisis in 2009. Still, exports were up 5% over August of 2014, but the development has to give Germans a reason for apprehension.

The biggest overseas buyers are in the U.S., non-euro zone EU countries, and Spain. China accounts for 6.5% of exports. Anyone counting on sales in China, Spain, and non-euro European countries for growth should be nervous right now. The U.S. is doing well comparatively, and we certainly have a strong currency, which helps us buy imports, but this is where VW lied about emissions!

In line with falling exports, industrial production was down 1.2% and manufacturer’s orders were off 1.8%. Both were up over August of 2014, but only by 2.5% and 2.2%, respectively. The decline was broad-based, coming from capital goods, consumer goods, energy and construction.

This is probably why the IMF lowered its estimate of German economic growth this year and next to 1.5% and 1.6%.

German officials have a different take, expecting growth at 1.8% in both years. But that assumes that China doesn’t suffer a hard landing, U.S. growth continues unabated with Americans buying German cars, no economic upheaval in the greater EU, and consistent orders from Spain.

And then there’s that little matter of dealing with massive waves of immigrants.

Germany took the lead on providing a destination for asylum-seekers. Now the country expects more than 1 million immigrants this year, up from 200,000 in 2014.

No matter what people think of the choice to grant asylum to so many, in a country of 84 million it will take some time and money to get everyone settled. And a similar number of refugees is expected in 2016, repeating the process.

The cost of handling the flow of people is estimated at $10 billion to $20 billion. That won’t break the German piggy-bank, but it still represents an additional cost at a time when so many other headwinds are already blowing.

Investors should underweight their exposure to Germany, or exit positions altogether. Better to step aside than get run over.